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The FTC Knows It When It Sees It

Ramsi Woodcock —  22 November 2022

[This post is a contribution to Truth on the Market‘s continuing digital symposium “FTC Rulemaking on Unfair Methods of Competition.” You can find other posts at the symposium page here. Truth on the Market also invites academics, practitioners, and other antitrust/regulation commentators to send us 1,500-4,000 word responses for potential inclusion in the symposium.]

When Congress created the Federal Trade Commission (FTC) in 1914, it charged the agency with condemning “unfair methods of competition.” That’s not the language Congress used in writing America’s primary antitrust statute, the Sherman Act, which prohibits “monopoliz[ation]” and “restraint[s] of trade.”

Ever since, the question has lingered whether the FTC has the authority to go beyond the Sherman Act to condemn conduct that is unfair, but not necessarily monopolizing or trade-restraining.

According to a new policy statement, the FTC’s current leadership seems to think that the answer is “yes.” But the peculiar strand of progressivism that is currently running the agency lacks the intellectual foundation needed to tell us what conduct that is unfair but not monopolizing might actually be—and misses an opportunity to bring about an expansion of its powers that courts might actually accept.

Better to Keep the Rule of Reason but Eliminate the Monopoly-Power Requirement

The FTC’s policy statement reads like a thesaurus. What is unfair competition? Answer: conduct that is “coercive, exploitative, collusive, abusive, deceptive, predatory, or involve[s] the use of economic power of a similar nature.”

In other words: the FTC has no idea. Presumably, the agency thinks, like Justice Potter Stewart did of obscenity, it will know it when it sees it. Given the courts’ long history of humiliating the FTC by rejecting its cases, even when the agency is able to provide a highly developed account of why challenged conduct is bad for America, one shudders to think of the reception such an approach to fairness will receive.

The one really determinate proposal in the policy statement is to attack bad conduct regardless whether the defendant has monopoly power. “Section 5 does not require a separate showing of market power or market definition when the evidence indicates that such conduct tends to negatively affect competitive conditions,” writes the FTC.

If only the agency had proposed this change alone, instead of cracking open the thesaurus to try to redefine bad conduct as well. Dropping the monopoly-power requirement would, by itself, greatly increase the amount of conduct subject to the FTC’s writ without forcing the agency to answer the metaphysical question: what is fair?

Under the present rule-of-reason approach, the courts let consumers answer the question of what constitutes bad conduct. Or to be precise, the courts assume that the only thing consumers care about is the product—its quality and price—and they try to guess whether consumers prefer the changes that the defendant’s conduct had on products in the market. If a court thinks consumers don’t prefer the changes, then the court condemns the conduct. But only if the defendant happens to have monopoly power in the market for those products.

Preserving this approach to identifying bad conduct would let the courts continue to maintain the pretense that they are doing the bidding of consumers—a role they will no doubt prefer to deciding what is fair as an absolute matter.

The FTC can safely discard the monopoly-power requirement without disturbing the current test for bad conduct because—as I argue in a working paper and as Timothy J. Brennen has long insisted—the monopoly-power requirement is directed at the wrong level of the supply chain: the market in which the defendant has harmed competition rather than the input market through which the defendant causes harm.

Power, not just in markets but in all social life, is rooted in one thing only: control over what others need. Harm to competition depends not on how much a defendant can produce relative to competitors but on whether a defendant controls an input that competitors need, but which the defendant can deny to them.

What others need, they do not buy from the market for which they produce. They buy what they need from other markets: input markets. It follows that the only power that should matter for antitrust—the only power that determines whether a firm can harm competition—is power over input markets, not power in the market in which competition is harmed.

And yet, apart from vertical-merger and contracting cases, where an inquiry into foreclosure of inputs still occasionally makes an appearance, antitrust today never requires systematic proof of power in input markets. The efforts of economists are wasted on the proof of power at the wrong level of the supply chain.

That represents an opportunity for the FTC, which can at one stroke greatly expand its authority to encompass conduct by firms having little power in the markets in which they harm competition.

To be sure, really getting the rule of reason right would require that proof of monopoly power continue to be required, only now at the input level instead of in the downstream market in which competition is harmed. But the courts have traditionally required only informal proof of power over inputs. The FTC could probably eliminate the economics-intensive process of formal proof of monopoly power entirely, instead of merely kicking it up one level in the supply chain.

That is surely an added plus for a current leadership so fearful of computation that it was at pains in the policy statement specifically to forswear “numerical” cost-benefit analysis.

Whatever Happened to No Fault?  

The FTC’s interest in expanding enforcement by throwing off the monopoly-power requirement is a marked departure from progressive antimonopolisms of the past. Mid-20th century radicals did not attack the monopoly-power side of antitrust’s two-part test, but rather the anticompetitive-conduct side.

For more than two decades, progressives mooted establishing a “no-fault” monopolization regime in which the only requirement for liability was size. By contrast, the present movement has sought to focus on conduct, rather than size, its own anti-concentration rhetoric notwithstanding.

Anti-Economism

That might, in part, be a result of the movement’s hostility toward economics. Proof of monopoly power is a famously economics-heavy undertaking.

The origin of contemporary antimonopolism is in activism by journalists against the social-media companies that are outcompeting newspapers for ad revenue, not in academia. As a result, the best traditions of the left, which involve intellectually outflanking opponents by showing how economic theory supports progressive positions, are missing here.

Contemporary antimonopolism has no “Capital” (Karl Marx), no “Progress and Poverty” (Henry George), and no “Freedom through Law” (Robert Hale). The most recent installment in this tradition of left-wing intellectual accomplishment is “Capital in the 21st Century” (Thomas Piketty). Unfortunately for progressive antimonopolists, it states: “pure and perfect competition cannot alter . . . inequality[.]’”

The contrast with the last revolution to sweep antitrust—that of the Chicago School—could not be starker. That movement was born in academia and its triumph was a triumph of ideas, however flawed they may in fact have been.

If one wishes to understand how Chicago School thinking put an end to the push for “no-fault” monopolization, one reads the Airlie House conference volume. In the conversations reproduced therein, one finds the no-faulters slowly being won over by the weight of data and theory deployed against them in support of size.

No equivalent watershed moment exists for contemporary antimonopolism, which bypassed academia (including the many progressive scholars doing excellent work therein) and went straight to the press and the agencies.

There is an ongoing debate about whether recent increases in markups result from monopolization or scarcity. It has not been resolved.

Rather than occupy economics, contemporary antimonopolists—and, perhaps, current FTC leadership—recoil from it. As one prominent antimonopolist lamented to a New York Times reporter, merger cases should be a matter of counting to four, and “[w]e don’t need economists to help us count to four.”

As the policy statement puts it: “The unfair methods of competition framework explicitly contemplates a variety of non-quantifiable harms, and justifications and purported benefits may be unquantifiable as well.”

Moralism

Contemporary antimonopolism’s focus on conduct might also be due to moralism—as reflected in the litany of synonyms for “bad” in the FTC’s policy statement.

For earlier progressives, antitrust was largely a means to an end—a way of ensuring that wages were high, consumer prices were low, and products were safe and of good quality. The fate of individual business entities within markets was of little concern, so long as these outcomes could be achieved.

What mattered were people. While contemporary antimonopolism cares about people, too, it differs from earlier antimonopolisms in that it personifies the firm.

If the firm dies, we are to be sad. If the firm is treated roughly by others, starved of resources or denied room to grow and reach its full potential, we are to be outraged, just as we would be if a child were starved. And, just as in the case of a child, we are to be outraged even if the firm would not have grown up to contribute anything of worth to society.

The irony, apparently lost on antimonopolists, is that the same personification of the firm as a rights-bearing agent, operating in other areas of law, undermines progressive policies.

The firm personified not only has a right to be treated gently by competing firms but also to be treated well by other people. But that means that people no longer come first relative to firms. When the Supreme Court holds that a business firm has a First Amendment right to influence politics, the Court takes personification of the firm to its logical extreme.

The alternative is not to make the market a morality play among firms, but to focus instead on market outcomes that matter to people—wages, prices, and product quality. We should not care whether a firm is “coerc[ed], exploitat[ed], collu[ded against], abus[ed], dece[ived], predate[ed], or [subjected to] economic power of a similar nature” except insofar as such treatment fails to serve people.

If one firm wishes to hire away the talent of another, for example, depriving the target of its lifeblood and killing it, so much the better if the result is better products, lower prices, or higher wages.

Antitrust can help maintain this focus on people only in part—by stopping unfair conduct that degrades products. I have argued elsewhere that the rest is for price regulation, taxation, and direct regulation to undertake.  

Can We Be Fairer and Still Give Product-Improving Conduct a Pass?

The intellectual deficit in contemporary antimonopolism is also evident in the care that the FTC’s policy statement puts into exempting behavior that creates superior products.

For one cannot expand the FTC’s powers to reach bad conduct without condemning product-improving conduct when the major check on enforcement today under the rule of reason (apart from the monopoly-power requirement) is precisely that conduct that improves products is exempt.

Under the rule of reason, bad conduct is a denial of inputs to a competitor that does not help consumers, meaning that the denial degrades the competitor’s products without improving the defendant’s products. Bad conduct is, in other words, unfairness that does not improve products.

If the FTC’s goal is to increase fairness relative to a regime that already pursues it, except when unfairness improves products, the additional fairness must come at the cost of product improvement.

The reference to superior products in the policy statement may be an attempt to compromise with the rule of reason. Unlike the elimination of the monopoly-power requirement, it is not a coherent compromise.

The FTC doesn’t need an economist to grasp this either.  

In Antitrust & Competition, Federal Trade Commission, FTC UMC Rulemaking, Monopolization, Section 5, Supreme Court, Symposia, Truth on the Market , , , , , , , , , , , ,
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Lina Khan’s Christmas Wish Is To Have Margrethe Vestager’s Powers

Dirk Auer —  16 November 2022

[This post is a contribution to Truth on the Market‘s continuing digital symposium “FTC Rulemaking on Unfair Methods of Competition.” You can find other posts at the symposium page here. Truth on the Market also invites academics, practitioners, and other antitrust/regulation commentators to send us 1,500-4,000 word responses for potential inclusion in the symposium.]

Federal Trade Commission (FTC) Chair Lina Khan has just sent her holiday wishlist to Santa Claus. It comes in the form of a policy statement on unfair methods of competition (UMC) that the FTC approved last week by a 3-1 vote. If there’s anything to be gleaned from the document, it’s that Khan and the agency’s majority bloc wish they could wield the same powers as Margrethe Vestager does in the European Union. Luckily for consumers, U.S. courts are unlikely to oblige.

Signed by the commission’s three Democratic commissioners, the UMC policy statement contains language that would be completely at home in a decision of the European Commission. It purports to reorient UMC enforcement (under Section 5 of the FTC Act) around typically European concepts, such as “competition on the merits.” This is an unambiguous repudiation of the rule of reason and, with it, the consumer welfare standard.

Unfortunately for its authors, these European-inspired aspirations are likely to fall flat. For a start, the FTC almost certainly does not have the power to enact such sweeping changes. More fundamentally, these concepts have been tried in the EU, where they have proven to be largely unworkable. On the one hand, critics (including the European judiciary) have excoriated the European Commission for its often economically unsound policymaking—enabled by the use of vague standards like “competition on the merits.” On the other hand, the Commission paradoxically believes that its competition powers are insufficient, creating the need for even stronger powers. The recently passed Digital Markets Act (DMA) is designed to fill this need.

As explained below, there is thus every reason to believe the FTC’s UMC statement will ultimately go down as a mistake, brought about by the current leadership’s hubris.

A Statement Is Just That

The first big obstacle to the FTC’s lofty ambitions is that its leadership does not have the power to rewrite either the FTC Act or courts’ interpretation of it. The agency’s leadership understands this much. And with that in mind, they ostensibly couch their statement in the case law of the U.S. Supreme Court:

Consistent with the Supreme Court’s interpretation of the FTC Act in at least twelve decisions, this statement makes clear that Section 5 reaches beyond the Sherman and Clayton Acts to encompass various types of unfair conduct that tend to negatively affect competitive conditions.

It is telling, however, that the cases cited by the agency—in a naked attempt to do away with economic analysis and the consumer welfare standard—are all at least 40 years old. Antitrust and consumer-protection laws have obviously come a long way since then, but none of that is mentioned in the statement. Inconvenient case law is simply shrugged off. To make matters worse, even the cases the FTC cites provide, at best, exceedingly weak support for its proposed policy.

For instance, as Commissioner Christine Wilson aptly notes in her dissenting statement, “the policy statement ignores precedent regarding the need to demonstrate anticompetitive effects.” Chief among these is the Boise Cascade Corp. v. FTC case, where the 9th U.S. Circuit Court of Appeals rebuked the FTC for failing to show actual anticompetitive effects:

In truth, the Commission has provided us with little more than a theory of the likely effect of the challenged pricing practices. While this general observation perhaps summarizes all that follows, we offer  the following specific points in support of our conclusion.

There is a complete absence of meaningful evidence in the record that price levels in the southern plywood industry reflect an anticompetitive effect.

In short, the FTC’s statement is just that—a statement. Gus Hurwitz summarized this best in his post:

Today’s news that the FTC has adopted a new UMC Policy Statement is just that: mere news. It doesn’t change the law. It is non-precedential and lacks the force of law. It receives the benefit of no deference. It is, to use a term from the consumer-protection lexicon, mere puffery.

Lina’s European Dream

But let us imagine, for a moment, that the FTC has its way and courts go along with its policy statement. Would this be good for the American consumer? In order to answer this question, it is worth looking at competition enforcement in the European Union.

There are, indeed, striking similarities between the FTC’s policy statement and European competition law. Consider the resemblance between the following quotes, drawn from the FTC’s policy statement (“A” in each example) and from the European competition sphere (“B” in each example).

Example 1 – Competition on the merits and the protection of competitors:

A. The method of competition must be unfair, meaning that the conduct goes beyond competition on the merits.… This may include, for example, conduct that tends to foreclose or impair the opportunities of market participants, reduce competition between rivals, limit choice, or otherwise harm consumers. (here)

B. The emphasis of the Commission’s enforcement activity… is on safeguarding the competitive process… and ensuring that undertakings which hold a dominant position do not exclude their competitors by other means than competing on the merits… (here)

Example 2 – Proof of anticompetitive harm:

A. “Unfair methods of competition” need not require a showing of current anticompetitive harm or anticompetitive intent in every case. … [T]his inquiry does not turn to whether the conduct directly caused actual harm in the specific instance at issue. (here)

B. The Commission cannot be required… systematically to establish a counterfactual scenario…. That would, moreover, oblige it to demonstrate that the conduct at issue had actual effects, which…  is not required in the case of an abuse of a dominant position, where it is sufficient to establish that there are potential effects. (here)

    Example 3 – Multiple goals:

    A. Given the distinctive goals of Section 5, the inquiry will not focus on the “rule of reason” inquiries more common in cases under the Sherman Act, but will instead focus on stopping unfair methods of competition in their incipiency based on their tendency to harm competitive conditions. (here)

    B. In its assessment the Commission should pursue the objectives of preserving and fostering innovation and the quality of digital products and services, the degree to which prices are fair and competitive, and the degree to which quality or choice for business users and for end users is or remains high. (here)

    Beyond their cosmetic resemblances, these examples reflect a deeper similarity. The FTC is attempting to introduce three core principles that also undergird European competition enforcement. The first is that enforcers should protect “the competitive process” by ensuring firms compete “on the merits,” rather than a more consequentialist goal like the consumer welfare standard (which essentially asks how a given practice affects economic output). The second is that enforcers should not be required to establish that conduct actually harms consumers. Instead, they need only show that such an outcome is (or will be) possible. The third principle is that competition policies pursue multiple, sometimes conflicting, goals.

    In short, the FTC is trying to roll back U.S. enforcement to a bygone era predating the emergence of the consumer welfare standard (which is somewhat ironic for the agency’s progressive leaders). And this vision of enforcement is infused with elements that appear to be drawn directly from European competition law.

    Europe Is Not the Land of Milk and Honey

    All of this might not be so problematic if the European model of competition enforcement that the FTC now seeks to emulate was an unmitigated success, but that could not be further from the truth. As Geoffrey Manne, Sam Bowman, and I argued in a recently published paper, the European model has several shortcomings that militate against emulating it (the following quotes are drawn from that paper). These problems would almost certainly arise if the FTC’s statement was blessed by courts in the United States.

    For a start, the more open-ended nature of European competition law makes it highly vulnerable to political interference. This is notably due to its multiple, vague, and often conflicting goals, such as the protection of the “competitive process”:

    Because EU regulators can call upon a large list of justifications for their enforcement decisions, they are free to pursue cases that best fit within a political agenda, rather than focusing on the limited practices that are most injurious to consumers. In other words, there is largely no definable set of metrics to distinguish strong cases from weak ones under the EU model; what stands in its place is political discretion.

    Politicized antitrust enforcement might seem like a great idea when your party is in power but, as Milton Friedman wisely observed, the mark of a strong system of government is that it operates well with the wrong person in charge. With this in mind, the FTC’s current leadership would do well to consider what their political opponents might do with these broad powers—such as using Section 5 to prevent online platforms from moderating speech.

    A second important problem with the European model is that, because of its competitive-process goal, it does not adequately distinguish between exclusion resulting from superior efficiency and anticompetitive foreclosure:

    By pursuing a competitive process goal, European competition authorities regularly conflate desirable and undesirable forms of exclusion precisely on the basis of their effect on competitors. As a result, the Commission routinely sanctions exclusion that stems from an incumbent’s superior efficiency rather than welfare-reducing strategic behavior, and routinely protects inefficient competitors that would otherwise rightly be excluded from a market.

    This vastly enlarges the scope of potential antitrust liability, leading to risks of false positives that chill innovative behavior and create nearly unwinnable battles for targeted firms, while increasing compliance costs because of reduced legal certainty. Ultimately, this may hamper technological evolution and protect inefficient firms whose eviction from the market is merely a reflection of consumer preferences.

    Finally, the European model results in enforcers having more discretion and enjoying greater deference from the courts:

    [T]he EU process is driven by a number of laterally equivalent, and sometimes mutually exclusive, goals.… [A] large problem exists in the discretion that this fluid arrangement of goals yields.

    The Microsoft case illustrates this problem well. In Microsoft, the Commission could have chosen to base its decision on a number of potential objectives. It notably chose to base its findings on the fact that Microsoft’s behavior reduced “consumer choice”. The Commission, in fact, discounted arguments that economic efficiency may lead to consumer welfare gains because “consumer choice” among a variety of media players was more important.

    In short, the European model sorely lacks limiting principles. This likely explains why the European Court of Justice has started to pare back the commission’s powers in a series of recent cases, including Intel, Post Danmark, Cartes Bancaires, and Servizio Elettrico Nazionale. These rulings appear to be an explicit recognition that overly broad competition enforcement not only fails to benefit consumers but, more fundamentally, is incompatible with the rule of law.

    It is unfortunate that the FTC is trying to emulate a model of competition enforcement that—even in the progressively minded European public sphere—is increasingly questioned and cast aside as a result of its multiple shortcomings.

    In Antitrust & Competition, European Union, Exclusive Dealing, Federal Trade Commission, FTC UMC Rulemaking, Section 5, Supreme Court, Symposia, Truth on the Market , , , , , , , , , , , , , ,
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    The Case Against Self-Preferencing as a New Antitrust Offense

    Giuseppe Colangelo —  22 September 2022

    The practice of so-called “self-preferencing” has come to embody the zeitgeist of competition policy for digital markets, as legislative initiatives are undertaken in jurisdictions around the world that to seek, in various ways, to constrain large digital platforms from granting favorable treatment to their own goods and services. The core concern cited by policymakers is that gatekeepers may abuse their dual role—as both an intermediary and a trader operating on the platform—to pursue a strategy of biased intermediation that entrenches their power in core markets (defensive leveraging) and extends it to associated markets (offensive leveraging).

    In addition to active interventions by lawmakers, self-preferencing has also emerged as a new theory of harm before European courts and antitrust authorities. Should antitrust enforcers be allowed to pursue such a theory, they would gain significant leeway to bypass the legal standards and evidentiary burdens traditionally required to prove that a given business practice is anticompetitive. This should be of particular concern, given the broad range of practices and types of exclusionary behavior that could be characterized as self-preferencing—only some of which may, in some specific contexts, include exploitative or anticompetitive elements.

    In a new working paper for the International Center for Law & Economics (ICLE), I provide an overview of the relevant traditional antitrust theories of harm, as well as the emerging case law, to analyze whether and to what extent self-preferencing should be considered a new standalone offense under EU competition law. The experience to date in European case law suggests that courts have been able to address platforms’ self-preferencing practices under existing theories of harm, and that it may not be sufficiently novel to constitute a standalone theory of harm.

    European Case Law on Self-Preferencing

    Practices by digital platforms that might be deemed self-preferencing first garnered significant attention from European competition enforcers with the European Commission’s Google Shopping investigation, which examined whether the search engine’s results pages positioned and displayed its own comparison-shopping service more favorably than the websites of rival comparison-shopping services. According to the Commission’s findings, Google’s conduct fell outside the scope of competition on the merits and could have the effect of extending Google’s dominant position in the national markets for general Internet search into adjacent national markets for comparison-shopping services, in addition to protecting Google’s dominance in its core search market.

    Rather than explicitly posit that self-preferencing (a term the Commission did not use) constituted a new theory of harm, the Google Shopping ruling described the conduct as belonging to the well-known category of “leveraging.” The Commission therefore did not need to propagate a new legal test, as it held that the conduct fell under a well-established form of abuse. The case did, however, spur debate over whether the legal tests the Commission did apply effectively imposed on Google a principle of equal treatment of rival comparison-shopping services.

    But it should be noted that conduct similar to that alleged in the Google Shopping investigation actually came before the High Court of England and Wales several months earlier, this time in a dispute between Google and Streetmap. At issue in that case was favorable search results Google granted to its own maps, rather than to competing online maps. The UK Court held, however, that the complaint should have been appropriately characterized as an allegation of discrimination; it further found that Google’s conduct did not constitute anticompetitive foreclosure. A similar result was reached in May 2020 by the Amsterdam Court of Appeal in the Funda case.  

    Conversely, in June 2021, the French Competition Authority (AdlC) followed the European Commission into investigating Google’s practices in the digital-advertising sector. Like the Commission, the AdlC did not explicitly refer to self-preferencing, instead describing the conduct as “favoring.”

    Given this background and the proliferation of approaches taken by courts and enforcers to address similar conduct, there was significant anticipation for the judgment that the European General Court would ultimately render in the appeal of the Google Shopping ruling. While the General Court upheld the Commission’s decision, it framed self-preferencing as a discriminatory abuse. Further, the Court outlined four criteria that differentiated Google’s self-preferencing from competition on the merits.

    Specifically, the Court highlighted the “universal vocation” of Google’s search engine—that it is open to all users and designed to index results containing any possible content; the “superdominant” position that Google holds in the market for general Internet search; the high barriers to entry in the market for general search services; and what the Court deemed Google’s “abnormal” conduct—behaving in a way that defied expectations, given a search engine’s business model, and that changed after the company launched its comparison-shopping service.

    While the precise contours of what the Court might consider discriminatory abuse aren’t yet clear, the decision’s listed criteria appear to be narrow in scope. This stands at odds with the much broader application of self-preferencing as a standalone abuse, both by the European Commission itself and by some national competition authorities (NCAs).

    Indeed, just a few weeks after the General Court’s ruling, the Italian Competition Authority (AGCM) handed down a mammoth fine against Amazon over preferential treatment granted to third-party sellers who use the company’s own logistics and delivery services. Rather than reflecting the qualified set of criteria laid out by the General Court, the Italian decision was clearly inspired by the Commission’s approach in Google Shopping. Where the Commission described self-preferencing as a new form of leveraging abuse, AGCM characterized Amazon’s practices as tying.

    Self-preferencing has also been raised as a potential abuse in the context of data and information practices. In November 2020, the European Commission sent Amazon a statement of objections detailing its preliminary view that the company had infringed antitrust rules by making systematic use of non-public business data, gathered from independent retailers who sell on Amazon’s marketplace, to advantage the company’s own retail business. (Amazon responded with a set of commitments currently under review by the Commission.)

    Both the Commission and the U.K. Competition and Markets Authority have lodged similar allegations against Facebook over data gathered from advertisers and then used to compete with those advertisers in markets in which Facebook is active, such as classified ads. The Commission’s antitrust proceeding against Apple over its App Store rules likewise highlights concerns that the company may use its platform position to obtain valuable data about the activities and offers of its competitors, while competing developers may be denied access to important customer data.

    These enforcement actions brought by NCAs and the Commission appear at odds with the more bounded criteria set out by the General Court in Google Shopping, and raise tremendous uncertainty regarding the scope and definition of the alleged new theory of harm.

    Self-Preferencing, Platform Neutrality, and the Limits of Antitrust Law

    The growing tendency to invoke self-preferencing as a standalone theory of antitrust harm could serve two significant goals for European competition enforcers. As mentioned earlier, it offers a convenient shortcut that could allow enforcers to skip the legal standards and evidentiary burdens traditionally required to prove anticompetitive behavior. Moreover, it can function, in practice, as a means to impose a neutrality regime on digital gatekeepers, with the aims of both ensuring a level playing field among competitors and neutralizing the potential conflicts of interests implicated by dual-mode intermediation.

    The dual roles performed by some platforms continue to fuel the never-ending debate over vertical integration, as well as related concerns that, by giving preferential treatment to its own products and services, an integrated provider may leverage its dominance in one market to related markets. From this perspective, self-preferencing is an inevitable byproduct of the emergence of ecosystems.

    However, as the Australian Competition and Consumer Commission has recognized, self-preferencing conduct is “often benign.” Furthermore, the total value generated by an ecosystem depends on the activities of independent complementors. Those activities are not completely under the platform’s control, although the platform is required to establish and maintain the governance structures regulating access to and interactions around that ecosystem.

    Given this reality, a complete ban on self-preferencing may call the very existence of ecosystems into question, challenging their design and monetization strategies. Preferential treatment can take many different forms with many different potential effects, all stemming from platforms’ many different business models. This counsels for a differentiated, case-by-case, and effects-based approach to assessing the alleged competitive harms of self-preferencing.

    Antitrust law does not impose on platforms a general duty to ensure neutrality by sharing their competitive advantages with rivals. Moreover, possessing a competitive advantage does not automatically equal an anticompetitive effect. As the European Court of Justice recently stated in Servizio Elettrico Nazionale, competition law is not intended to protect the competitive structure of the market, but rather to protect consumer welfare. Accordingly, not every exclusionary effect is detrimental to competition. Distinctions must be drawn between foreclosure and anticompetitive foreclosure, as only the latter may be penalized under antitrust.

    In Antitrust & Competition, European Union, Exclusionary Conduct, Google, Platforms, Price Discrimination, Truth on the Market, Tying, United Kingdom , , , , , , , , , , , , , , , ,
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    In Apple v Epic, 9th Circuit Should Remember that Antitrust Forbids Enhancing, not Exercising, Market Power

    Thom Lambert —  1 April 2022

    On March 31, I and several other law and economics scholars filed an amicus brief in Epic Games v. Apple, which is on appeal to the U.S. Court of Appeals for Ninth Circuit.  In this post, I summarize the central arguments of the brief, which was joined by Alden Abbott, Henry Butler, Alan Meese, Aurelien Portuese, and John Yun and prepared with the assistance of Don Falk of Schaerr Jaffe LLP.

    First, some background for readers who haven’t followed the case.

    Epic, maker of the popular Fortnite video game, brought antitrust challenges against two policies Apple enforces against developers of third-party apps that run on iOS, the mobile operating system for Apple’s popular iPhones and iPads.  One policy requires that all iOS apps be distributed through Apple’s own App Store.  The other requires that any purchases of digital goods made while using an iOS app utilize Apple’s In App Purchase system (IAP).  Apple collects a share of the revenue from sales made through its App Store and using IAP, so these two policies provide a way for it to monetize its innovative app platform.   

    Epic maintains that Apple’s app policies violate the federal antitrust laws.  Following a trial, the district court disagreed, though it condemned another of Apple’s policies under California state law.  Epic has appealed the antitrust rulings against it. 

    My fellow amici and I submitted our brief in support of Apple to draw the Ninth Circuit’s attention to a distinction that is crucial to ensuring that antitrust promotes long-term consumer welfare: the distinction between the mere extraction of surplus through the exercise of market power and the enhancement of market power via the weakening of competitive constraints.

    The central claim of our brief is that Epic’s antitrust challenges to Apple’s app store policies should fail because Epic has not shown that the policies enhance Apple’s market power in any market.  Moreover, condemnation of the practices would likely induce Apple to use its legitimately obtained market power to extract surplus in a different way that would leave consumers worse off than they are under the status quo.   

    Mere Surplus Extraction vs. Market Power Extension

    As the Supreme Court has observed, “Congress designed the Sherman Act as a ‘consumer welfare prescription.’”  The Act endeavors to protect consumers from harm resulting from “market power,” which is the ability of a firm lacking competitive constraints to enhance its profits by reducing its output—either quantitively or qualitatively—from the level that would persist if the firm faced vigorous competition.  A monopolist, for example, might cut back on the quantity it produces (to drive up market price) or it might skimp on quality (to enhance its per-unit profit margin).  A firm facing vigorous competition, by contrast, couldn’t raise market price simply by reducing its own production, and it would lose significant sales to rivals if it raised its own price or unilaterally cut back on product quality.  Market power thus stems from deficient competition.

    As Dennis Carlton and Ken Heyer have observed, two different types of market power-related business behavior may injure consumers and are thus candidates for antitrust prohibition.  One is an exercise of market power: an action whereby a firm lacking competitive constraints increases its returns by constricting its output so as to raise price or otherwise earn higher profit margins.  When a firm engages in this sort of conduct, it extracts a greater proportion of the wealth, or “surplus,” generated by its transactions with its customers.

    Every voluntary transaction between a buyer and seller creates surplus, which is the difference between the subjective value the consumer attaches to an item produced and the cost of producing and distributing it.  Price and other contract terms determine how that surplus is allocated between the buyer and the seller.  When a firm lacking competitive constraints exercises its market power by, say, raising price, it extracts for itself a greater proportion of the surplus generated by its sale.

    The other sort of market power-related business behavior involves an effort by a firm to enhance its market power by weakening competitive constraints.  For example, when a firm engages in unreasonably exclusionary conduct that drives its rivals from the market or increases their costs so as to render them less formidable competitors, its market power grows.

    U.S. antitrust law treats these two types of market power-related conduct differently.  It forbids behavior that enhances market power and injures consumers, but it permits actions that merely exercise legitimately obtained market power without somehow enhancing it.  For example, while charging a monopoly price creates immediate consumer harm by extracting for the monopolist a greater share of the surplus created by the transaction, the Supreme Court observed in Trinko that “[t]he mere possession of monopoly power, and the concomitant charging of monopoly prices, is not . . . unlawful.”  (See also linkLine: “Simply possessing monopoly power and charging monopoly prices does not violate [Sherman Act] § 2….”)

    Courts have similarly refused to condemn mere exercises of market power in cases involving surplus-extractive arrangements more complicated than simple monopoly pricing.  For example, in its Independent Ink decision, the U.S. Supreme Court expressly declined to adopt a rule that would have effectively banned “metering” tie-ins.

    In a metering tie-in, a seller with market power on some unique product that is used with a competitively supplied complement that is consumed in varying amounts—say, a highly unique printer that uses standard ink—reduces the price of its unique product (the printer), requires buyers to also purchase from it their requirements of the complement (the ink), and then charges a supracompetitive price for the latter product.  This allows the seller to charge higher effective prices to high-volume users of its unique tying product (buyers who use lots of ink) and lower prices to lower-volume users. 

    Assuming buyers’ use of the unique product correlates with the value they ascribe to it, a metering tie-in allows the seller to price discriminate, charging higher prices to buyers who value its unique product more.  This allows the seller to extract more of the surplus generated by sales of its product, but it in no way extends the seller’s market power.

    In refusing to adopt a rule that would have condemned most metering tie-ins, the Independent Ink Court observed that “it is generally recognized that [price discrimination] . . . occurs in fully competitive markets” and that tying arrangements involving requirements ties may be “fully consistent with a free, competitive market.” The Court thus reasoned that mere price discrimination and surplus extraction, even when accomplished through some sort of contractual arrangement like a tie-in, are not by themselves anticompetitive harms warranting antitrust’s condemnation.    

    The Ninth Circuit has similarly recognized that conduct that exercises market power to extract surplus but does not somehow enhance that power does not create antitrust liability.  In Qualcomm, the court refused to condemn the chipmaker’s “no license, no chips” policy, which enabled it to enhance its profits by earning royalties on original equipment manufacturers’ sales of their high-priced products.

    In reversing the district court’s judgment in favor of the FTC, the Ninth Circuit conceded that Qualcomm’s policies were novel and that they allowed it to enhance its profits by extracting greater surplus.  The court refused to condemn the policies, however, because they did not injure competition by weakening competitive constraints:

    This is not to say that Qualcomm’s “no license, no chips” policy is not “unique in the industry” (it is), or that the policy is not designed to maximize Qualcomm’s profits (Qualcomm has admitted as much). But profit-seeking behavior alone is insufficient to establish antitrust liability. As the Supreme Court stated in Trinko, the opportunity to charge monopoly prices “is an important element of the free-market system” and “is what attracts ‘business acumen’ in the first place; it induces risk taking that produces innovation and economic growth.”

    The Qualcomm court’s reference to Trinko highlights one reason courts should not condemn exercises of market power that merely extract surplus without enhancing market power: allowing such surplus extraction furthers dynamic efficiency—welfare gain that accrues over time from the development of new and improved products and services.

    Dynamic efficiency results from innovation, which entails costs and risks.  Firms are more willing to incur those costs and risks if their potential payoff is higher, and an innovative firm’s ability to earn supracompetitive profits off its “better mousetrap” enhances its payoff. 

    Allowing innovators to extract such profits also helps address the fact most of the benefits of product innovation inure to people other than the innovator.  Private actors often engage in suboptimal levels of behaviors that produce such benefit spillovers, or “positive externalities,”  because they bear all the costs of those behaviors but capture just a fraction of the benefit produced.  By enhancing the benefits innovators capture from their innovative efforts, allowing non-power-enhancing surplus extraction helps generate a closer-to-optimal level of innovative activity.

    Not only do supracompetitive profits extracted through the exercise of legitimately obtained market power motivate innovation, they also enable it by helping to fund innovative efforts.  Whereas businesses that are forced by competition to charge prices near their incremental cost must secure external funding for significant research and development (R&D) efforts, firms collecting supracompetitive returns can finance R&D internally.  Indeed, of the top fifteen global spenders on R&D in 2018, eleven were either technology firms accused of possessing monopoly power (#1 Apple, #2 Alphabet/Google, #5 Intel, #6 Microsoft, #7 Apple, and #14 Facebook) or pharmaceutical companies whose patent protections insulate their products from competition and enable supracompetitive pricing (#8 Roche, #9 Johnson & Johnson, #10 Merck, #12 Novartis, and #15 Pfizer).

    In addition to fostering dynamic efficiency by motivating and enabling innovative efforts, a policy acquitting non-power-enhancing exercises of market power allows courts to avoid an intractable question: which instances of mere surplus extraction should be precluded?

    Precluding all instances of surplus extraction by firms with market power would conflict with precedents like Trinko and linkLine (which say that legitimate monopolists may legally charge monopoly prices) and would be impracticable given the ubiquity of above-cost pricing in niche and brand-differentiated markets.

    A rule precluding surplus extraction when accomplished by a practice more complicated that simple monopoly pricing—say, some practice that allows price discrimination against buyers who highly value a product—would be both arbitrary and backward.  The rule would be arbitrary because allowing supracompetitive profits from legitimately obtained market power motivates and enables innovation regardless of the means used to extract surplus. The rule would be backward because, while simple monopoly pricing always reduces overall market output (as output-reduction is the very means by which the producer causes price to rise), more complicated methods of extracting surplus, such as metering tie-ins, often enhance market output and overall social welfare.

    A third possibility would be to preclude exercising market power to extract more surplus than is necessary to motivate and enable innovation.  That position, however, would require courts to determine how much surplus extraction is required to induce innovative efforts.  Courts are poorly positioned to perform such a task, and their inevitable mistakes could significantly chill entrepreneurial activity.

    Consider, for example, a firm contemplating a $5 million investment that might return up to $50 million.  Suppose the managers of the firm weighed expected costs and benefits and decided the risky gamble was just worth taking.  If the gamble paid off but a court stepped in and capped the firm’s returns at $20 million—a seemingly generous quadrupling of the firm’s investment—future firms in the same position would not make similar investments.  After all, the firm here thought this gamble was just barely worth taking, given the high risk of failure, when available returns were $50 million.

    In the end, then, the best policy is to draw the line as both the U.S. Supreme Court and the Ninth Circuit have done: Whereas enhancements of market power are forbidden, merely exercising legitimately obtained market power to extract surplus is permitted.

    Apple’s Policies Do Not Enhance Its Market Power

    Under the legal approach described above, the two Apple policies Epic has challenged do not give rise to antitrust liability.  While the policies may boost Apple’s profits by facilitating its extraction of surplus from app transactions on its mobile devices, they do not enhance Apple’s market power in any conceivable market.

    As the creator and custodian of the iOS operating system, Apple has the ability to control which applications will run on its iPhones and iPads.  Developers cannot produce operable iOS apps unless Apple grants them access to the Application Programming Interfaces (APIs) required to enable the functionality of the operating system and hardware. In addition, Apple can require developers to obtain digital certificates that will enable their iOS apps to operate.  As the district court observed, “no certificate means the code will not run.”

    Because Apple controls which apps will work on the operating system it created and maintains, Apple could collect the same proportion of surplus it currently extracts from iOS app sales and in-app purchases on iOS apps even without the policies Epic is challenging.  It could simply withhold access to the APIs or digital certificates needed to run iOS apps unless developers promised to pay it 30% of their revenues from app sales and in-app purchases of digital goods.

    This means that the challenged policies do not give Apple any power it doesn’t already possess in the putative markets Epic identified: the markets for “iOS app distribution” and “iOS in-app payment processing.” 

    The district court rejected those market definitions on the ground that Epic had not established cognizable aftermarkets for iOS-specific services.  It defined the relevant market instead as “mobile gaming transactions.”  But no matter.  The challenged policies would not enhance Apple’s market power in that broader market either.

    In “mobile gaming transactions” involving non-iOS (e.g., Android) mobile apps, Apple’s policies give it no power at all.  Apple doesn’t distribute non-iOS apps or process in-app payments on such apps.  Moreover, even if Apple were to being doing so—say, by distributing Android apps in its App Store or allowing producers of Android apps to include IAP as their in-app payment system—it is implausible that Apple’s policies would allow it to gain new market power.  There are giant, formidable competitors in non-iOS app distribution (e.g., Google’s Play Store) and in payment processing for non-iOS in-app purchases (e.g., Google Play Billing).  It is inconceivable that Apple’s policies would allow it to usurp so much scale from those rivals that Apple could gain market power over non-iOS mobile gaming transactions.

    That leaves only the iOS segment of the mobile gaming transactions market.  And, as we have just seen, Apple’s policies give it no new power to extract surplus from those transactions; because it controls access to iOS, it could do so using other means.

    Nor do the challenged policies enable Apple to maintain its market power in any conceivable market.  This is not a situation like Microsoft where a firm in a market adjacent to a monopolist’s could somehow pose a challenge to that monopolist, and the monopolist nips the potential competition in the bud by reducing the potential rival’s scale.  There is no evidence in the record to support the (implausible) notion that rival iOS app stores or in-app payment processing systems could ever evolve in a manner that would pose a challenge to Apple’s position in mobile devices, mobile operating systems, or any other market in which it conceivably has market power. 

    Epic might retort that but for the challenged policies, rivals could challenge Apple’s market share in iOS app distribution and in-app purchase processing.  Rivals could not, however, challenge Apple’s market power in such markets, as that power stems from its control of iOS.  The challenged policies therefore do not enable Apple to shore up any existing market power.

    Alternative Means of Extracting Surplus Would Likely Reduce Consumer Welfare

    Because the policies Epic has challenged are not the source of Apple’s ability to extract surplus from iOS app transactions, judicial condemnation of the policies would likely induce Apple to extract surplus using different means.  Changing how it earns profits off iOS app usage, however, would likely leave consumers worse off than they are under the status quo.

    Apple could simply charge third-party app developers a flat fee for access to the APIs needed to produce operable iOS apps but then allow them to distribute their apps and process in-app payments however they choose.  Such an approach would allow Apple to monetize its innovative app platform while permitting competition among providers of iOS app distribution and in-app payment processing services.  Relative to the status quo, though, such a model would likely reduce consumer welfare by:

    • Reducing the number of free and niche apps,as app developers could no longer avoid a fee to Apple by adopting a free (likely ad-supported) business model, and producers of niche apps may not generate enough revenue to justify Apple’s flat fee;
    • Raising business risks for app developers, who, if Apple cannot earn incremental revenue off sales and use of their apps, may face a greater likelihood that the functionality of those apps will be incorporated into future versions of iOS;
    • Reducing Apple’s incentive to improve iOS and its mobile devices, as eliminating Apple’s incremental revenue from app usage reduces its motivation to make costly enhancements that keep users on their iPhones and iPads;
    • Raising the price of iPhones and iPads and generating deadweight loss, as Apple could no longer charge higher effective prices to people who use apps more heavily and would thus likely hike up its device prices, driving marginal consumers from the market; and
    • Reducing user privacy and security, as jettisoning a closed app distribution model (App Store only) would impair Apple’s ability to screen iOS apps for features and bugs that create security and privacy risks.

    An alternative approach—one that would avoid many of the downsides just stated by allowing Apple to continue earning incremental revenue off iOS app usage—would be for Apple to charge app developers a revenue-based fee for access to the APIs and other amenities needed to produce operable iOS apps.  That approach, however, would create other costs that would likely leave consumers worse off than they are under the status quo.

    The policies Epic has challenged allow Apple to collect a share of revenues from iOS app transactions immediately at the point of sale.  Replacing those policies with a revenue-based  API license system would require Apple to incur additional costs of collecting revenues and ensuring that app developers are accurately reporting them.  In order to extract the same surplus it currently collects—and to which it is entitled given its legitimately obtained market power—Apple would have to raise its revenue-sharing percentage above its current commission rate to cover its added collection and auditing costs.

    The fact that Apple has elected not to adopt this alternative means of collecting the revenues to which it is entitled suggests that the added costs of moving to the alternative approach (extra collection and auditing costs) would exceed any additional consumer benefit such a move would produce.  Because Apple can collect the same revenue percentage from app transactions two different ways, it has an incentive to select the approach that maximizes iOS app transaction revenues.  That is the approach that creates the greatest value for consumers and also for Apple. 

    If Apple believed that the benefits to app users of competition in app distribution and in-app payment processing would exceed the extra costs of collection and auditing, it would have every incentive to switch to a revenue-based licensing regime and increase its revenue share enough to cover its added collection and auditing costs.  As such an approach would enhance the net value consumers receive when buying apps and making in-app purchases, it would raise overall app revenues, boosting Apple’s bottom line.  The fact that Apple has not gone in this direction, then, suggests that it does not believe consumers would receive greater benefit under the alternative system.  Apple might be wrong, of course.  But it has a strong motivation to make the consumer welfare-enhancing decision here, as doing so maximizes its own profits.

    The policies Epic has challenged do not enhance or shore up Apple’s market power, a salutary pre-requisite to antitrust liability.  Furthermore, condemning the policies would likely lead Apple to monetize its innovative app platform in a manner that would reduce consumer welfare relative to the status quo.  The Ninth Circuit should therefore affirm the district court’s rejection of Epic’s antitrust claims.  

    In Antitrust & Competition, Apple, Economic Theory, Exclusionary Conduct, Exclusive Dealing, Law & Economics, Platforms, Supreme Court, Truth on the Market, Tying , , , , , , , ,
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    Antitrust Lessons from AT&T’s M&A Fiasco

    Jonathan M. Barnett —  24 May 2021
    Image by Gerd Altmann from Pixabay

    AT&T’s $102 billion acquisition of Time Warner in 2019 will go down in M&A history as an exceptionally ill-advised transaction, resulting in the loss of tens of billions of dollars of shareholder value. It should also go down in history as an exceptional ill-chosen target of antitrust intervention.  The U.S. Department of Justice, with support from many academic and policy commentators, asserted with confidence that the vertical combination of these content and distribution powerhouses would result in an entity that could exercise market power to the detriment of competitors and consumers.

    The chorus of condemnation continued with vigor even after the DOJ’s loss in court and AT&T’s consummation of the transaction. With AT&T’s May 17 announcement that it will unwind the two-year-old acquisition and therefore abandon its strategy to integrate content and distribution, it is clear these predictions of impending market dominance were unfounded. 

    This widely shared overstatement of antitrust risk derives from a simple but fundamental error: regulators and commentators were looking at the wrong market.  

    The DOJ’s Antitrust Case against the Transaction

    The business case for the AT&T/Time Warner transaction was straightforward: it promised to generate synergies by combining a leading provider of wireless, broadband, and satellite television services with a leading supplier of video content. The DOJ’s antitrust case against the transaction was similarly straightforward: the combined entity would have the ability to foreclose “must have” content from other “pay TV” (cable and satellite television) distributors, resulting in adverse competitive effects. 

    This foreclosure strategy was expected to take two principal forms. First, AT&T could temporarily withhold (or threaten to withhold) content from rival distributors absent payment of a higher carriage fee, which would then translate into higher fees for subscribers. Second, AT&T could permanently withhold content from rival distributors, who would then lose subscribers to AT&T’s DirectTV satellite television service, further enhancing AT&T’s market power. 

    Many commentators, both in the trade press and significant portions of the scholarly community, characterized the transaction as posing a high-risk threat to competitive conditions in the pay TV market. These assertions reflected the view that the new entity would exercise a bottleneck position over video-content distribution in the pay TV market and would exercise that power to impose one-sided terms to the detriment of content distributors and consumers. 

    Notwithstanding this bevy of endorsements, the DOJ’s case was rejected by the district court and the decision was upheld by the D.C. appellate court. The district judge concluded that the DOJ had failed to show that the combined entity would exercise any credible threat to withhold “must have” content from distributors. A key reason: the lost carriage fees AT&T would incur if it did withhold content were so high, and the migration of subscribers from rival pay TV services so speculative, that it would represent an obviously irrational business strategy. In short: no sophisticated business party would ever take AT&T’s foreclosure threat seriously, in which case the DOJ’s predictions of market power were insufficiently compelling to justify the use of government power to block the transaction.

    The Fundamental Flaws in the DOJ’s Antitrust Case

    The logical and factual infirmities of the DOJ’s foreclosure hypothesis have been extensively and ably covered elsewhere and I will not repeat that analysis. Following up on my previous TOTM commentary on the transaction, I would like to emphasize the point that the DOJ’s case against the transaction was flawed from the outset for two more fundamental reasons. 

    False Assumption #1

    The assumption that the combined entity could withhold so-called “must have” content to cause significant and lasting competitive injury to rival distributors flies in the face of market realities.  Content is an abundant, renewable, and mobile resource. There are few entry barriers to the content industry: a commercially promising idea will likely attract capital, which will in turn secure the necessary equipment and personnel for production purposes. Any rival distributor can access a rich menu of valuable content from a plethora of sources, both domestically and worldwide, each of which can provide new content, as required. Even if the combined entity held a license to distribute purportedly “must have” content, that content would be up for sale (more precisely, re-licensing) to the highest bidder as soon as the applicable contract term expired. This is not mere theorizing: it is a widely recognized feature of the entertainment industry.

    False Assumption #2

    Even assuming the combined entity could wield a portfolio of “must have” content to secure a dominant position in the pay TV market and raise content acquisition costs for rival pay TV services, it still would lack any meaningful pricing power in the relevant consumer market. The reason: significant portions of the viewing population do not want any pay TV or only want dramatically “slimmed-down” packages. Instead, viewers increasingly consume content primarily through video-streaming services—a market in which platforms such as Amazon and Netflix already enjoyed leading positions at the time of the transaction. Hence, even accepting the DOJ’s theory that the combined entity could somehow monopolize the pay TV market consisting of cable and satellite television services, the theory still fails to show any reasonable expectation of anticompetitive effects in the broader and economically relevant market comprising pay TV and streaming services.  Any attempt to exercise pricing power in the pay TV market would be economically self-defeating, since it would likely prompt a significant portion of consumers to switch to (or start to only use) streaming services.

    The Antitrust Case for the Transaction

    When properly situated within the market that was actually being targeted in the AT&T/Time Warner acquisition, the combined entity posed little credible threat of exercising pricing power. To the contrary, the combined entity was best understood as an entrant that sought to challenge the two pioneer entities—Amazon and Netflix—in the “over the top” content market.

    Each of these incumbent platforms individually had (and have) multi-billion-dollar content production budgets that rival or exceed the budgets of major Hollywood studios and enjoy worldwide subscriber bases numbering in the hundreds of millions. If that’s not enough, AT&T was not the only entity that observed the displacement of pay TV by streaming services, as illustrated by the roughly concurrent entry of Disney’s Disney+ service, Apple’s Apple TV+ service, Comcast NBCUniversal’s Peacock service, and others. Both the existing and new competitors are formidable entities operating in a market with formidable capital requirements. In 2019, Netflix, Amazon, and Apple TV expended approximately $15 billion, $6 billion, and again, $6 billion, respectively, on content; by contrast, HBO Max, AT&T’s streaming service, expended approximately $3.5 billion. 

    In short, the combined entity faced stiff competition from existing and reasonably anticipated competitors, requiring several billions of dollars on “content spend” to even stay in the running. Far from being able to exercise pricing power in an imaginary market defined by DOJ litigators for strategic purposes, the AT&T/Time Warner entity faced the challenge of merely surviving in a real-world market populated by several exceptionally well-financed competitors. At best, the combined entity “threatened” to deliver incremental competitive benefits by adding a robust new platform to the video-streaming market; at worst, it would fail in this objective and cause no incremental competitive harm. As it turns out, the latter appears to be the case.

    The Enduring Virtues of Antitrust Prudence

    AT&T’s M&A fiasco has important lessons for broader antitrust debates about the evidentiary standards that should be applied by courts and agencies when assessing alleged antitrust violations, in general, and vertical restraints, in particular.  

    Among some scholars, regulators, and legislators, it has become increasingly received wisdom that prevailing evidentiary standards, as reflected in federal case law and agency guidelines, are excessively demanding, and have purportedly induced chronic underenforcement. It has been widely asserted that the courts’ and regulators’ focus on avoiding “false positives” and the associated costs of disrupting innocuous or beneficial business practices has resulted in an overly cautious enforcement posture, especially with respect to mergers and vertical restraints.

    In fact, these views were expressed by some commentators in endorsing the antitrust case against the AT&T/Time-Warner transaction. Some legislators have gone further and argued for substantial amendments to the antitrust law to provide enforcers and courts with greater latitude to block or re-engineer combinations that would not pose sufficiently demonstrated competitive risks under current statutory or case law.

    The swift downfall of the AT&T/Time-Warner transaction casts great doubt on this critique and accompanying policy proposals. It was precisely the district court’s rigorous application of those “overly” demanding evidentiary standards that avoided what would have been a clear false-positive error. The failure of the “blockbuster” combination to achieve not only market dominance, but even reasonably successful entry, validates the wisdom of retaining those standards.

    The fundamental mismatch between the widely supported antitrust case against the transaction and the widely overlooked business realities of the economically relevant consumer market illustrates the ease with which largely theoretical and decontextualized economic models of competitive harm can lead to enforcement actions that lack any reasonable basis in fact.   

    In Amazon, Antitrust & Competition, Antitrust Division, Apple, Broadband, Justice Department, Market Definition, Platforms, Telecommunications, Truth on the Market, Vertical Restraints, Wireless , , , , , , , , , , , , , , , ,
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    Google and Shifting Conceptions of What It Means to Improve a Product

    Ramsi Woodcock —  16 December 2020

    [TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

    Judges sometimes claim that they do not pick winners when they decide antitrust cases. Nothing could be further from the truth.

    Competitive conduct by its nature harms competitors, and so if antitrust were merely to prohibit harm to competitors, antitrust would then destroy what it is meant to promote.

    What antitrust prohibits, therefore, is not harm to competitors but rather harm to competitors that fails to improve products. Only in this way is antitrust able to distinguish between the good firm that harms competitors by making superior products that consumers love and that competitors cannot match and the bad firm that harms competitors by degrading their products without offering consumers anything better than what came before.

    That means, however, that antitrust must pick winners: antitrust must decide what is an improvement and what not. And a more popular search engine is a clear winner.

    But one should not take its winningness for granted. For once upon a time there was another winner that the courts always picked, blocking antitrust case after antitrust case. Until one day the courts stopped picking it.

    That was the economy of scale.

    The Structure of the Google Case

    Like all antitrust cases that challenge the exercise of power, the government’s case against Google alleges denial of an input to competitors in some market. Here the input is default search status in smartphones, the competitors are rival search providers, and the market is search advertising. The basic structure of the case is depicted in the figure below.

    Although brought as a monopolization case under Section 2 of the Sherman Act, this is at heart an exclusive dealing case of the sort normally brought under Section 1 of the Sherman Act: the government’s core argument is that Google uses contracts with smartphone makers, pursuant to which the smartphone makers promise to make Google, and not competitors, the search default, to harm competing search advertising providers and by extension competition in the search advertising market.

    The government must show anticompetitive conduct, monopoly power, and consumer harm in order to prevail.

    Let us assume that there is monopoly power. The company has more than 70% of the search advertising market, which is in the zone normally required to prove that element of a monopolization claim.

    The problem of anticompetitive conduct is only slightly more difficult.

    Anticompetitive conduct is only ever one thing in antitrust: denial of an essential input to a competitor. There is no other way to harm rivals.

    (To be sure, antitrust prohibits harm to competition, not competitors, but that means only that harm to competitors necessary but insufficient for liability. The consumer harm requirement decides whether the requisite harm to competitors is also harm to competition.)

    It is not entirely clear just how important default search status really is to running a successful search engine, but let us assume that it is essential, as the government suggests.

    Then the question whether Google’s contracts are anticompetitive turns on how much of the default search input Google’s contracts foreclose to rival search engines. If a lot, then the rivals are badly harmed. If a little, then there may be no harm at all.

    The answer here is that there is a lot of foreclosure, at least if the government’s complaint is to be believed. Through its contracts with Apple and makers of Android phones, Google has foreclosed default search status to rivals on virtually every single smartphone.

    That leaves consumer harm. And here is where things get iffy.

    Usage as a Product Improvement: A Very Convenient Argument

    The inquiry into consumer harm evokes measurements of the difference between demand curves and price lines, or extrapolations of compensating and equivalent variation using indifference curves painstakingly pieced together based on the assumptions of revealed preference.

    But while the parties may pay experts plenty to spin such yarns, and judges may pretend to listen to them, in the end, for the judges, it always comes down to one question only: did exclusive dealing improve the product?

    If it did, then the judge assumes that the contracts made consumers better off and the defendant wins. And if it did not, then off with their heads.

    So, does foreclosing all this default search space to competitors make Google search advertising more valuable to advertisers?

    Those who leap to Google’s defense say yes, for default search status increases the number of people who use Google’s search engine. And the more people use Google’s search engine, the more Google learns about how best to answer search queries and which advertisements will most interest which searchers. And that ensures that even more people will use Google’s search engine, and that Google will do an even better job of targeting ads on its search engine.

    And that in turn makes Google’s search advertising even better: able to reach more people and to target ads more effectively to them.

    None of that would happen if defaults were set to other engines and users spurned Google, and so foreclosing default search space to rivals undoubtedly improves Google’s product.

    This is a nice argument. Indeed, it is almost too nice, for it seems to suggest that almost anything Google might do to steer users away from competitors and to itself deserves antitrust immunity. Suppose Google were to brandish arms to induce you to run your next search on Google. That would be a crime, but, on this account, not an antitrust crime. For getting you to use Google does make Google better.

    The argument that locking up users improves the product is of potential use not just to Google but to any of the many tech companies that run on advertising—Facebook being a notable example—so it potentially immunizes an entire business model from antitrust scrutiny.

    It turns out that has happened before.

    Economies of Scale as a Product Improvement: Once a Convenient Argument

    Once upon a time, antitrust exempted another kind of business for which products improve the more people used them. The business was industrial production, and it differs from online advertising only in the irrelevant characteristic that the improvement that comes with expanding use is not in the quality of the product but in the cost per unit of producing it.

    The hallmark of the industrial enterprise is high fixed costs and low marginal costs. The textile mill differs from pre-industrial piecework weaving in that once a $10 million investment in machinery has been made, the mill can churn out yard after yard of cloth for pennies. The pieceworker, by contrast, makes a relatively small up-front investment—the cost of raising up the hovel in which she labors and making her few tools—but spends the same large amount of time to produce each new yard of cloth.

    Large fixed costs and low marginal costs lie at the heart of the bounty of the modern age: the more you produce, the lower the unit cost, and so the lower the price at which you can sell your product. This is a recipe for plenty.

    But it also means that, so long as consumer demand in a given market is lower than the capacity of any particular plant, driving buyers to a particular seller and away from competitors always improves the product, in the sense that it enables the firm to increase volume and reduce unit cost, and therefore to sell the product at a lower price.

    If the promise of the modern age is goods at low prices, then the implication is that antitrust should never punish firms for driving rivals from the market and taking over their customers. Indeed, efficiency requires that only one firm should ever produce in any given market, at least in any market for which a single plant is capable of serving all customers.

    For antitrust in the late 19th and early 20th centuries, beguiled by this advantage to size, exclusive dealing, refusals to deal, even the knife in a competitor’s back: whether these ran afoul of other areas of law or not, it was all for the better because it allowed industrial enterprises to achieve economies of scale.

    It is no accident that, a few notable triumphs aside, antitrust did not come into its own until the mid-1930s, 40 years after its inception, on the heels of an intellectual revolution that explained, for the first time, why it might actually be better for consumers to have more than one seller in a market.

    The Monopolistic Competition Revolution

    The revolution came in the form of the theory of monopolistic competition and its cousin, the theory of creative destruction, developed between the 1920s and 1940s by Edward Chamberlin, Joan Robinson and Joseph Schumpeter.

    These theories suggested that consumers might care as much about product quality as they do about product cost, and indeed would be willing to abandon a low-cost product for a higher-quality, albeit more expensive, one.

    From this perspective, the world of economies of scale and monopoly production was the drab world of Soviet state-owned enterprises churning out one type of shoe, one brand of cleaning detergent, and so on.

    The world of capitalism and technological advance, by contrast, was one in which numerous firms produced batches of differentiated products in amounts sometimes too small fully to realize all scale economies, but for which consumers were nevertheless willing to pay because the products better fit their preferences.

    What is more, the striving of monopolistically competitive firms to lure away each other’s customers with products that better fit their tastes led to disruptive innovation— “creative destruction” was Schumpeter’s famous term for it—that brought about not just different flavors of the same basic concept but entirely new concepts. The competition to create a better flip phone, for example, would lead inevitably to a whole new paradigm, the smartphone.

    This reasoning combined with work in the 1940s and 1950s on economic growth that quantified for the first time the key role played by technological change in the vigor of capitalist economies—the famous Solow residual—to suggest that product improvements, and not the cost reductions that come from capital accumulation and their associated economies of scale, create the lion’s share of consumer welfare. Innovation, not scale, was king.

    Antitrust responded by, for the first time in its history, deciding between kinds of product improvements, rather than just in favor of improvements, casting economies of scale out of the category of improvements subject to antitrust immunity, while keeping quality improvements immune.

    Casting economies of scale out of the protected product improvement category gave antitrust something to do for the first time. It meant that big firms had to plead more than just the cost advantages of being big in order to obtain license to push their rivals around. And government could now start reliably to win cases, rather than just the odd cause célèbre.

    It is this intellectual watershed, and not Thurman Arnold’s tenacity, that was responsible for antitrust’s emergence as a force after World War Two.

    Usage-Based Improvements Are Not Like Economies of Scale

    The improvements in advertising that come from user growth fall squarely on the quality side of the ledger—the value they create is not due to the ability to average production costs over more ad buyers—and so they count as the kind of product improvements that antitrust continues to immunize today.

    But given the pervasiveness of this mode of product improvement in the tech economy—the fact that virtually any tech firm that sells advertising can claim to be improving a product by driving users to itself and away from competitors—it is worth asking whether we have not reached a new stage in economic development in which this form of product improvement ought, like economies of scale, to be denied protection.

    Shouldn’t the courts demand more and better innovation of big tech firms than just the same old big-data-driven improvements they serve up year after year?

    Galling as it may be to those who, like myself, would like to see more vigorous antitrust enforcement in general, the answer would seem to be “no.” For what induced the courts to abandon antitrust immunity for economies of scale in the mid-20th century was not the mere fact that immunizing economies of scale paralyzed antitrust. Smashing big firms is not, after all, an end in itself.

    Instead, monopolistic competition, creative destruction and the Solow residual induced the change, because they suggested both that other kinds of product improvement are more important than economies of scale and, crucially, that protecting economies of scale impedes development of those other kinds of improvements.

    A big firm that excludes competitors in order to reach scale economies not only excludes competitors who might have produced an identical or near-identical product, but also excludes competitors who might have produced a better-quality product, one that consumers would have preferred to purchase even at a higher price.

    To cast usage-based improvements out of the product improvement fold, a case must be made that excluding competitors in order to pursue such improvements will block a different kind of product improvement that contributes even more to consumer welfare.

    If we could say, for example, that suppressing search competitors suppresses more-innovative search engines that ad buyers would prefer, even if those innovative search engines were to lack the advantages that come from having a large user base, then a case might be made that user growth should no longer count as a product improvement immune from antitrust scrutiny.

    And even then, the case against usage-based improvements would need to be general enough to justify an epochal change in policy, rather than be limited to a particular technology in a particular lawsuit. For the courts hate to balance in individual cases, statements to the contrary in their published opinions notwithstanding.

    But there is nothing in the Google complaint, much less the literature, to suggest that usage-based improvements are problematic in this way. Indeed, much of the value created by the information revolution seems to inhere precisely in its ability to centralize usage.

    Americans Keep Voting to Centralize the Internet

    In the early days of the internet, theorists mistook its decentralized architecture for a feature, rather than a bug. But internet users have since shown, time and again, that they believe the opposite.

    For example, the basic protocols governing email were engineered to allow every American to run his own personal email server.

    But Americans hated the freedom that created—not least the spam—and opted instead to get their email from a single server: the one run by Google as Gmail.

    The basic protocols governing web traffic were also designed to allow every American to run whatever other communications services he wished—chat, video chat, RSS, webpages—on his own private server in distributed fashion.

    But Americans hated the freedom that created—not least having to build and rebuild friend networks across platforms–—and they voted instead overwhelmingly to get their social media from a single server: Facebook.

    Indeed, the basic protocols governing internet traffic were designed to allow every business to store and share its own data from its own computers, in whatever form.

    But American businesses hated that freedom—not least the cost of having to buy and service their own data storage machines—and instead 40% of the internet is now stored and served from Amazon Web Services.

    Similarly, advertisers have the option of placing advertisements on the myriad independently-run websites that make up the internet—known in the business as the “open web”—by placing orders through competitive ad exchanges. But advertisers have instead voted mostly to place ads on the handful of highly centralized platforms known as “walled gardens,” including Facebook, Google’s YouTube and, of course, Google Search.

    The communications revolution, they say, is all about “bringing people together.” It turns out that’s true.

    And that Google should win on consumer harm.

    Remember the Telephone

    Indeed, the same mid-20th century antitrust that thought so little of economies of scale as a defense immunized usage-based improvements when it encountered them in that most important of internet precursors: the telephone.

    The telephone, like most internet services, gets better as usage increases. The more people are on a particular telephone network, the more valuable the network becomes to subscribers.

    Just as with today’s internet services, the advantage of a large user base drove centralization of telephone services a century ago into the hands of a single firm: AT&T. Aside from a few business executives who liked the look of a desk full of handsets, consumers wanted one phone line that they could use to call everyone.

    Although the government came close to breaking AT&T up in the early 20th century, the government eventually backed off, because a phone system in which you must subscribe to the right carrier to reach a friend just doesn’t make sense.

    Instead, Congress and state legislatures stepped in to take the edge off monopoly by regulating phone pricing. And when antitrust finally did break AT&T up in 1982, it did so in a distinctly regulatory fashion, requiring that AT&T’s parts connect each other’s phone calls, something that Congress reinforced in the Telecommunications Act of 1996.

    The message was clear: the sort of usage-based improvements one finds in communications are real product improvements. And antitrust can only intervene if it has a way to preserve them.

    The equivalent of interconnection in search, that the benefits of usage, in the form of data and attention, be shared among competing search providers, might be feasible. But it is hard to imagine the court in the Google case ordering interconnection without the benefit of decades of regulatory experience with the defendant’s operations that the district court in 1982 could draw upon in the AT&T case.

    The solution for the tech giants today is the same as the solution for AT&T a century ago: to regulate rather than to antitrust.

    Microsoft Not to the Contrary, Because Users Were in Common

    Parallels to the government’s 1990s-era antitrust case against Microsoft are not to the contrary.

    As Sam Weinstein has pointed out to me, Microsoft, like Google, was at heart an exclusive dealing case: Microsoft contracted with computer manufacturers to prevent Netscape Navigator, an early web browser, from serving as the default web browser on Windows PCs.

    That prevented Netscape, the argument went, from growing to compete with Windows in the operating system market, much the way the Google’s Chrome browser has become a substitute for Windows on low-end notebook computers today.

    The D.C. Circuit agreed that default status was an essential input for Netscape as it sought eventually to compete with Windows in the operating system market.

    The court also accepted the argument that the exclusive dealing did not improve Microsoft’s operating system product.

    This at first seems to contradict the notion that usage improves products, for, like search advertising, operating systems get better as their user bases increase. The more people use an operating system, the more application developers are willing to write for the system, and the better the system therefore becomes.

    It seems to follow that keeping competitors off competing operating systems and on Windows made Windows better. If the court nevertheless held Microsoft liable, it must be because the court refused to extend antitrust immunity to usage-based improvements.

    The trouble with this line of argument is that it ignores the peculiar thing about the Microsoft case: that while the government alleged that Netscape was a potential competitor of Windows, Netscape was also an application that ran on Windows.

    That means that, unlike Google and rival search engines, Windows and Netscape shared users.

    So, Microsoft’s exclusive dealing did not increase its user base and therefore could not have improved Windows, at least not by making Windows more appealing for applications developers. Driving Netscape from Windows did not enable developers to reach even one more user. Conversely, allowing Netscape to be the default browser on Windows would not have reduced the number of Windows users, because Netscape ran on Windows.

    By contrast, a user who runs a search in Bing does not run the same search simultaneously in Google, and so Bing users are not Google users. Google’s exclusive dealing therefore increases its user base and improves Google’s product, whereas Microsoft’s exclusive dealing served only to reduce Netscape’s user base and degrade Netscape’s product.

    Indeed, if letting Netscape be the default browser on Windows was a threat to Windows, it was not because it prevented Microsoft from improving its product, but because Netscape might eventually have become an operating system, and indeed a better operating system, than Windows, and consumers and developers, who could be on both at the same time if they wished, might have nevertheless chosen eventually to go with Netscape alone.

    Though it does not help the government in the Google case, Microsoft still does offer a beacon of hope for those concerned about size, for Microsoft’s subsequent history reminds us that yesterday’s behemoth is often today’s also ran.

    And the favorable settlement terms Microsoft ultimately used to escape real consequences for its conduct 20 years ago imply that, at least in high-tech markets, we don’t always need antitrust for that to be true.

    In Amazon, Antitrust & Competition, Antitrust Division, Apple, Exclusive Dealing, Facebook, Google, Justice Department, Platforms, Symposia, Symposium on the Future of American Antitrust: The Google Lawsuits, Telecommunications, Truth on the Market , , , , , , , , , , , , , , ,
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    Manne & Stout 2: Against Incorporating a Contract/Merger Equivalency Assumption in Vertical Merger Guidelines

    Geoffrey Manne & Kristian Stout —  7 February 2020

    In our first post, we discussed the weaknesses of an important theoretical underpinning of efforts to expand vertical merger enforcement (including, possibly, the proposed guidelines): the contract/merger equivalency assumption.

    In this post we discuss the implications of that assumption and some of the errors it leads to — including some incorporated into the proposed guidelines.

    There is no theoretical or empirical justification for more vertical enforcement

    Tim Brennan makes a fantastic and regularly overlooked point in his post: If it’s true, as many claim (see, e.g., Steve Salop), that firms can generally realize vertical efficiencies by contracting instead of merging, then it’s also true that they can realize anticompetitive outcomes the same way. While efficiencies have to be merger-specific in order to be relevant to the analysis, so too do harms. But where the assumption is that the outcomes of integration can generally be achieved by the “less-restrictive” means of contracting, that would apply as well to any potential harms, thus negating the transaction-specificity required for enforcement. As Dennis Carlton notes:

    There is a symmetry between an evaluation of the harms and benefits of vertical integration. Each must be merger-specific to matter in an evaluation of the merger’s effects…. If transaction costs are low, then vertical integration creates neither benefits nor harms, since everything can be achieved by contract. If transaction costs exist to prevent the achievement of a benefit but not a harm (or vice-versa), then that must be accounted for in a calculation of the overall effect of a vertical merger. (Dennis Carlton, Transaction Costs and Competition Policy)

    Of course, this also means that those (like us) who believe that it is not so easy to accomplish by contract what may be accomplished by merger must also consider the possibility that a proposed merger may be anticompetitive because it overcomes an impediment to achieving anticompetitive goals via contract.

    There’s one important caveat, though: The potential harms that could arise from a vertical merger are the same as those that would be cognizable under Section 2 of the Sherman Act. Indeed, for a vertical merger to cause harm, it must be expected to result in conduct that would otherwise be illegal under Section 2. This means there is always the possibility of a second bite at the apple when it comes to thwarting anticompetitive conduct. 

    The same cannot be said of procompetitive conduct that can arise only through merger if a merger is erroneously prohibited before it even happens. 

    Interestingly, Salop himself — the foremost advocate today for enhanced vertical merger enforcement — recognizes the issue raised by Brennan: 

    Exclusionary harms and certain efficiency benefits also might be achieved with vertical contracts and agreements without the need for a vertical merger…. It [] might be argued that the absence of premerger exclusionary contracts implies that the merging firms lack the incentive to engage in conduct that would lead to harmful exclusionary effects. But anticompetitive vertical contracts may face the same types of impediments as procompetitive ones, and may also be deterred by potential Section 1 enforcement. Neither of these arguments thus justify a more or less intrusive vertical merger policy generally. Rather, they are factors that should be considered in analyzing individual mergers. (Salop & Culley, Potential Competitive Effects of Vertical Mergers)

    In the same article, however, Salop also points to the reasons why it should be considered insufficient to leave enforcement to Sections 1 and 2, instead of addressing them at their incipiency under Clayton Section 7:

    While relying solely on post-merger enforcement might have appealing simplicity, it obscures several key facts that favor immediate enforcement under Section 7.

    • The benefit of HSR review is to prevent the delays and remedial issues inherent in after-the-fact enforcement….
    • There may be severe problems in remedying the concern….
    • Section 1 and Section 2 legal standards are more permissive than Section 7 standards….
    • The agencies might well argue that anticompetitive post-merger conduct was caused by the merger agreement, so that it would be covered by Section 7….

    All in all, failure to address these kinds of issues in the context of merger review could lead to significant consumer harm and underdeterrence.

    The points are (mostly) well-taken. But they also essentially amount to a preference for more and tougher enforcement against vertical restraints than the judicial interpretations of Sections 1 & 2 currently countenance — a preference, in other words, for the use of Section 7 to bolster enforcement against vertical restraints of any sort (whether contractual or structural).

    The problem with that, as others have pointed out in this symposium (see, e.g., Nuechterlein; Werden & Froeb; Wright, et al.), is that there’s simply no empirical basis for adopting a tougher stance against vertical restraints in the first place. Over and over again the empirical research shows that vertical restraints and vertical mergers are unlikely to cause anticompetitive harm: 

    In reviewing this literature, two features immediately stand out: First, there is a paucity of support for the proposition that vertical restraints/vertical integration are likely to harm consumers. . . . Second, a far greater number of studies found that the use of vertical restraints in the particular context studied improved welfare unambiguously. (Cooper, et al, Vertical Restrictions and Antitrust Policy: What About the Evidence?)

    [W]e did not have a particular conclusion in mind when we began to collect the evidence, and we… are therefore somewhat surprised at what the weight of the evidence is telling us. It says that, under most circumstances, profit-maximizing, vertical-integration decisions are efficient, not just from the firms’ but also from the consumers’ points of view…. We therefore conclude that, faced with a vertical arrangement, the burden of evidence should be placed on competition authorities to demonstrate that that arrangement is harmful before the practice is attacked. (Francine Lafontaine & Margaret Slade, Vertical Integration and Firm Boundaries: The Evidence)

    [Table 1 in this paper] indicates that voluntarily adopted restraints are associated with lower costs, greater consumption, higher stock returns, and better chances of survival. (Daniel O’Brien, The Antitrust Treatment of Vertical Restraint: Beyond the Beyond the Possibility Theorems)

    In sum, these papers from 2009-2018 continue to support the conclusions from Lafontaine & Slade (2007) and Cooper et al. (2005) that consumers mostly benefit from vertical integration. While vertical integration can certainly foreclose rivals in theory, there is only limited empirical evidence supporting that finding in real markets. (GAI Comment on Vertical Mergers)

    To the extent that the proposed guidelines countenance heightened enforcement relative to the status quo, they fall prey to the same defect. And while it is unclear from the fairly terse guidelines whether this is animating them, the removal of language present in the 1984 Non-Horizontal Merger Guidelines acknowledging the relative lack of harm from vertical mergers (“[a]lthough non-horizontal mergers are less likely than horizontal mergers to create competitive problems…”) is concerning.  

    The shortcomings of orthodox economics and static formal analysis

    There is also a further reason to think that vertical merger enforcement may be more likely to thwart procompetitive than anticompetitive arrangements relative to the status quo ante (i.e., where arrangements among vertical firms are by contract): Our lack of knowledge about the effects of market structure and firm organization on innovation and dynamic competition, and the relative hostility to nonstandard contracting, including vertical integration:

    [T]he literature addressing how market structure affects innovation (and vice versa) in the end reveals an ambiguous relationship in which factors unrelated to competition play an important role. (Katz & Shelanski, Mergers and Innovation)

    The fixation on the equivalency of the form of vertical integration (i.e., merger versus contract) is likely to lead enforcers to focus on static price and cost effects, and miss the dynamic organizational and informational effects that lead to unexpected, increased innovation across and within firms. 

    In the hands of Oliver Williamson, this means that understanding firms in the real world entails taking an organization theory approach, in contrast to the “orthodox” economic perspective:

    The lens of contract approach to the study of economic organization is partly complementary but also partly rival to the orthodox [neoclassical economic] lens of choice. Specifically, whereas the latter focuses on simple market exchange, the lens of contract is predominantly concerned with the complex contracts. Among the major differences is that non‐standard and unfamiliar contractual practices and organizational structures that orthodoxy interprets as manifestations of monopoly are often perceived to serve economizing purposes under the lens of contract. A major reason for these and other differences is that orthodoxy is dismissive of organization theory whereas organization theory provides conceptual foundations for the lens of contract. (emphasis added)

    We are more likely to miss it when mergers solve market inefficiencies, and more likely to see it when they impose static costs — even if the apparent costs actually represent a move from less efficient contractual arrangements to more efficient integration.

    The competition that takes place in the real world and between various groups ultimately depends upon the institution of private contracts, many of which, including the firm itself, are nonstandard. Innovation includes the discovery of new organizational forms and the application of old forms to new contexts. Such contracts prevent or attenuate market failure, moving the market toward what economists would deem a more competitive result. Indeed, as Professor Coase pointed out, many markets deemed “perfectly competitive” are in fact the end result of complex contracts limiting rivalry between competitors. This contractual competition cannot produce perfect results — no human institution ever can. Nonetheless, the result is superior to that which would obtain in a (real) world without nonstandard contracting. These contracts do not depend upon the creation or enhancement of market power and thus do not produce the evils against which antitrust law is directed. (Alan Meese, Price Theory Competition & the Rule of Reason)

    Or, as Oliver Williamson more succinctly puts it:

    [There is a] rebuttable presumption that nonstandard forms of contracting have efficiency purposes. (Oliver Williamson, The Economic Institutions of Capitalism)

    The pinched focus of the guidelines on narrow market definition misses the bigger picture of dynamic competition over time

    The proposed guidelines (and the theories of harm undergirding them) focus upon indicia of market power that may not be accurate if assessed in more realistic markets or over more relevant timeframes, and, if applied too literally, may bias enforcement against mergers with dynamic-innovation benefits but static-competition costs.  

    Similarly, the proposed guidelines’ enumeration of potential efficiencies doesn’t really begin to cover the categories implicated by the organization of enterprise around dynamic considerations. 

    The proposed guidelines’ efficiencies section notes that:

    Vertical mergers bring together assets used at different levels in the supply chain to make a final product. A single firm able to coordinate how these assets are used may be able to streamline production, inventory management, or distribution, or create innovative products in ways that would have been hard to achieve though arm’s length contracts. (emphasis added)

    But it is not clear than any of these categories encompasses organizational decisions made to facilitate the coordination of production and commercialization when they are dependent upon intangible assets.

    As Thomas Jorde and David Teece write:

    For innovations to be commercialized, the economic system must somehow assemble all the relevant complementary assets and create a dynamically-efficient interactive system of learning and information exchange. The necessary complementary assets can conceivably be assembled by either administrative or market processes, as when the innovator simply licenses the technology to firms that already own or are willing to create the relevant assets. These organizational choices have received scant attention in the context of innovation. Indeed, the serial model relies on an implicit belief that arm’s-length contracts between unaffiliated firms in the vertical chain from research to customer will suffice to commercialize technology. In particular, there has been little consideration of how complex contractual arrangements among firms can assist commercialization — that is, translating R&D capability into profitable new products and processes….

    * * *

    But in reality, the market for know-how is riddled with imperfections. Simple unilateral contracts where technology is sold for cash are unlikely to be efficient. Complex bilateral and multilateral contracts, internal organization, or various hybrid structures are often required to shore up obvious market failures and create procompetitive efficiencies. (Jorde & Teece, Rule of Reason Analysis of Horizontal Arrangements: Agreements Designed to Advance Innovation and Commercialize Technology) (emphasis added)

    When IP protection for a given set of valuable pieces of “know-how” is strong — easily defendable, unique patents, for example — firms can rely on property rights to efficiently contract with vertical buyers and sellers. But in cases where the valuable “know how” is less easily defended as IP — e.g. business process innovation, managerial experience, distributed knowledge, corporate culture, and the like — the ability to partially vertically integrate through contract becomes more difficult, if not impossible. 

    Perhaps employing these assets is part of what is meant in the draft guidelines by “streamline.” But the very mention of innovation only in the technological context of product innovation is at least some indication that organizational innovation is not clearly contemplated.  

    This is a significant lacuna. The impact of each organizational form on knowledge transfers creates a particularly strong division between integration and contract. As Enghin Atalay, Ali Hortaçsu & Chad Syverson point out:

    That vertical integration is often about transfers of intangible inputs rather than physical ones may seem unusual at first glance. However, as observed by Arrow (1975) and Teece (1982), it is precisely in the transfer of nonphysical knowledge inputs that the market, with its associated contractual framework, is most likely to fail to be a viable substitute for the firm. Moreover, many theories of the firm, including the four “elemental” theories as identified by Gibbons (2005), do not explicitly invoke physical input transfers in their explanations for vertical integration. (Enghin Atalay, et al., Vertical Integration and Input Flows) (emphasis added)

    There is a large economics and organization theory literature discussing how organizations are structured with respect to these sorts of intangible assets. And the upshot is that, while we start — not end, as some would have it — with the Coasian insight that firm boundaries are necessarily a function of production processes and not a hard limit, we quickly come to realize that it is emphatically not the case that integration-via-contract and integration-via-merger are always, or perhaps even often, viable substitutes.

    Conclusion

    The contract/merger equivalency assumption, coupled with a “least-restrictive alternative” logic that favors contract over merger, puts a thumb on the scale against vertical mergers. While the proposed guidelines as currently drafted do not necessarily portend the inflexible, formalistic application of this logic, they offer little to guide enforcers or courts away from the assumption in the important (and perhaps numerous) cases where it is unwarranted.   

    In Amazon, Antitrust & Competition, Apple, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Intellectual Property, Justice Department, Market Definition, Merger Guidelines, Patent, Platforms, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , ,
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    Manne & Stout 1: The Illogic of a Contract/Merger Equivalency Assumption in the Assessment of Vertical Mergers

    Geoffrey Manne & Kristian Stout —  7 February 2020

    [TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

    This post is authored by Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics ); and Kristian Stout (Associate Director, ICLE).]

    As many in the symposium have noted — and as was repeatedly noted during the FTC’s Hearings on Competition and Consumer Protection in the 21st Century — there is widespread dissatisfaction with the 1984 Non-Horizontal Merger Guidelines. 

    Although it is doubtless correct that the 1984 guidelines don’t reflect the latest economic knowledge, it is by no means clear that this has actually been a problem — or that a new set of guidelines wouldn’t create even greater problems. Indeed, as others have noted in this symposium, there is a great deal of ambiguity in the proposed guidelines that could lead either to uncertainty as to how the agencies will exercise their discretion, or, more troublingly, could lead courts to take seriously speculative theories of harm. 

    We can do little better in expressing our reservations that new guidelines are needed than did the current Chairman of the FTC, Joe Simons, writing on this very blog in a symposium on what became the 2010 Horizontal Merger Guidelines. In a post entitled, Revisions to the Merger Guidelines: Above All, Do No Harm, Simons writes:

    My sense is that there is no need to revise the DOJ/FTC Horizontal Merger Guidelines, with one exception…. The current guidelines lay out the general framework quite well and any change in language relative to that framework are likely to create more confusion rather than less. Based on my own experience, the business community has had a good sense of how the agencies conduct merger analysis…. If, however, the current administration intends to materially change the way merger analysis is conducted at the agencies, then perhaps greater revision makes more sense. But even then, perhaps the best approach is to try out some of the contemplated changes (i.e. in actual investigations) and publicize them in speeches and the like before memorializing them in a document that is likely to have some substantial permanence to it.

    Wise words. Unless, of course, “the current [FTC] intends to materially change the way [vertical] merger analysis is conducted.” But the draft guidelines don’t really appear to portend a substantial change, and in several ways they pretty accurately reflect agency practice.

    What we want to draw attention to, however, is an implicit underpinning of the draft guidelines that we believe the agencies should clearly disavow (or at least explain more clearly the complexity surrounding): the extent and implications of the presumed functional equivalence of vertical integration by contract and by merger — the contract/merger equivalency assumption.   

    Vertical mergers and their discontents

    The contract/merger equivalency assumption has been gaining traction with antitrust scholars, but it is perhaps most clearly represented in some of Steve Salop’s work. Salop generally believes that vertical merger enforcement should be heightened. Among his criticisms of current enforcement is his contention that efficiencies that can be realized by merger can often also be achieved by contract. As he discussed during his keynote presentation at last year’s FTC hearing on vertical mergers:

    And, finally, the key policy issue is the issue is not about whether or not there are efficiencies; the issue is whether the efficiencies are merger-specific. As I pointed out before, Coase stressed that you can get vertical integration by contract. Very often, you can achieve the vertical efficiencies if they occur, but with contracts rather than having to merge.

    And later, in the discussion following his talk:

    If there is vertical integration by contract… it meant you could get all the efficiencies from vertical integration with a contract. You did not actually need the vertical integration. 

    Salop thus argues that because the existence of a “contract solution” to firm problems can often generate the same sorts of efficiencies as when firms opt to merge, enforcers and courts should generally adopt a presumption against vertical mergers relative to contracting:

    Coase’s door swings both ways: Efficiencies often can be achieved by vertical contracts, without the potential anticompetitive harms from merger. 

    In that vertical restraints are characterized as “just” vertical integration “by contract,” then claimed efficiencies in problematical mergers might be achieved with non-merger contracts that do not raise the same anticompetitive concerns. (emphasis in original)

    (Salop isn’t alone in drawing such a conclusion, of course; Carl Shapiro, for example, has made a similar point (as have others)).

    In our next post we explore the policy errors implicated by this contract/merger equivalency assumption. But here we want to consider whether it makes logical sense in the first place. 

    The logic of vertical integration is not commutative 

    It is true that, where contracts are observed, they are likely as (or more, actually)  efficient than merger. But, by the same token, it is also true that where mergers are observed they are likely more efficient than contracts. Indeed, the entire reason for integration is efficiency relative to what could be done by contract — this is the essence of the so-called “make-or-buy” decision. 

    For example, a firm that decides to buy its own warehouse has determined that doing so is more efficient than renting warehouse space. Some of these efficiencies can be measured and quantified (e.g., carrying costs of ownership vs. the cost of rent), but many efficiencies cannot be easily measured or quantified (e.g., layout of the facility or site security). Under the contract/merger equivalency assumption, the benefits of owning a warehouse can be achieved “very often” by renting warehouse space. But the fact that many firms using warehouses own some space and rent some space indicates that the make-or-buy decision is often unique to each firm’s idiosyncratic situation. Moreover, the distinctions driving those differences will not always be readily apparent, and whether contracting or integrating is preferable in any given situation may not be inferred from the existence of one or the other elsewhere in the market — or even in the same firm!

    There is no reason to presume in any given situation that the outcome from contracting would be the same as from merging, even where both are notionally feasible. The two are, quite simply, different bargaining environments, each with a different risk and cost allocation; accounting treatment; effect on employees, customers, and investors; tax consequence, etc. Even if the parties accomplished nominally “identical” outcomes, they would not, in fact, be identical.

    Meanwhile, what if the reason for failure to contract, or the reason to prefer merger, has nothing to do with efficiency? What if there were no anticompetitive aim but there were a tax advantage? What if one of the parties just wanted a larger firm in order to satisfy the CEO’s ego? That these are not cognizable efficiencies under antitrust law is clear. But the adoption of a presumption of equivalence between contract and merger would — ironically — entail their incorporation into antitrust law just the same — by virtue of their effective prohibition under antitrust law. 

    In other words, if the assumption is that contract and merger are equally efficient unless proven otherwise, but the law adopts a suspicion (or, even worse, a presumption) that vertical mergers are anticompetitive which can be rebutted only with highly burdensome evidence of net efficiency gain, this effectively deputizes antitrust law to enforce a preconceived notion of “merger appropriateness” that does not necessarily turn on efficiencies. There may (or may not) be sensible policy reasons for adopting such a stance, but they aren’t antitrust reasons.

    More fundamentally, however, while there are surely some situations in which contractual restraints might be able to achieve similar organizational and efficiency gains as a merger, the practical realities of achieving not just greater efficiency, but a whole host of non-efficiency-related, yet nonetheless valid, goals, are rarely equivalent between the two. 

    It may be that the parties don’t know what they don’t know to such an extent that a contract would be too costly because it would be too incomplete, for example. But incomplete contracts and ambiguous control and ownership rights aren’t (as much of) an issue on an ongoing basis after a merger. 

    As noted, there is no basis for assuming that the structure of a merger and a contract would be identical. In the same way, there is no basis for assuming that the knowledge transfer that would result from a merger would be the same as that which would result from a contract — and in ways that the parties could even specify or reliably calculate in advance. Knowing that the prospect for knowledge “synergies” would be higher with a merger than a contract might be sufficient to induce the merger outcome. But asked to provide evidence that the parties could not engage in the same conduct via contract, the parties would be unable to do so. The consequence, then, would be the loss of potential gains from closer integration.

    At the same time, the cavalier assumption that parties would be able — legally — to enter into an analogous contract in lieu of a merger is problematic, given that it would likely be precisely the form of contract (foreclosing downstream or upstream access) that is alleged to create problems with the merger in the first place.

    At the FTC hearings last year, Francine LaFontaine highlighted this exact concern: 

    I want to reemphasize that there are also rules against vertical restraints in antitrust laws, and so to say that the firms could achieve the mergers outcome by using vertical restraints is kind of putting them in a circular motion where we are telling them you cannot merge because you could do it by contract, and then we say, but these contract terms are not acceptable.

    Indeed, legal risk is one of the reasons why a merger might be preferable to a contract, and because the relevant markets here are oligopoly markets, the possibility of impermissible vertical restraints between large firms with significant market share is quite real.

    More important, the assumptions underlying the contention that contracts and mergers are functionally equivalent legal devices fails to appreciate the importance of varied institutional environments. Consider that one reason some takeovers are hostile is because incumbent managers don’t want to merge, and often believe that they are running a company as well as it can be run — that a change of corporate control would not improve efficiency. The same presumptions may also underlie refusals to contract and, even more likely, may explain why, to the other firm, a contract would be ineffective.

    But, while there is no way to contract without bilateral agreement, there is a corporate control mechanism to force a takeover. In this institutional environment a merger may be easier to realize than a contract (and that applies even to a consensual merger, of course, given the hostile outside option). In this case, again, the assumption that contract should be the relevant baseline and the preferred mechanism for coordination is misplaced — even if other firms in the industry are successfully accomplishing the same thing via contract, and even if a contract would be more “efficient” in the abstract.

    Conclusion

    Properly understood, the choice of whether to contract or merge derives from a host of complicated factors, many of which are difficult to observe and/or quantify. The contract/merger equivalency assumption — and the species of “least-restrictive alternative” reasoning that would demand onerous efficiency arguments to permit a merger when a contract was notionally possible — too readily glosses over these complications and unjustifiably embraces a relative hostility to vertical mergers at odds with both theory and evidence. 

    Rather, as has long been broadly recognized, there can be no legally relevant presumption drawn against a company when it chooses one method of vertical integration over another in the general case. The agencies should clarify in the draft guidelines that the mere possibility of integration via contract or the inability of merging parties to rigorously describe and quantify efficiencies does not condemn a proposed merger.

    In Antitrust & Competition, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Google, Justice Department, Market Definition, Merger Guidelines, Platforms, Telecommunications, Truth on the Market, Tying, Vertical Restraints, Wireless , , , , , , , , , , , ,
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    White: The Missing Market Definition Standard in the Draft Vertical Guidelines

    Lawrence White —  7 February 2020

    [TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

    This post is authored by Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division).]

    The DOJ/FTC Draft Vertical Merger Guidelines establish a “safe harbor” of a 20% market share for each of the merging parties. But the issue of defining the relevant “market” to which the 20% would apply is not well addressed.

    Although reference is made to the market definition paradigm that is offered by the DOJ’s and FTC’s Horizontal Merger Guidelines (“HMGs”), what is neglected is the following: Under the “unilateral effects” theory of competitive harm of the HMGs, the horizontal merger of two firms that sell differentiated products that are imperfect substitutes could lead to significant price increases if the second-choice product for a significant fraction of each of the merging firms’ customers is sold by the partner firm. Such unilateral-effects instances are revealed by examining detailed sales and substitution data with respect to the customers of only the two merging firms.

    In such instances, the true “relevant market” is simply the products that are sold by the two firms, and the merger is effectively a “2-to-1” merger. Under these circumstances, any apparently broader market (perhaps based on physical or functional similarities of products) is misleading, and the “market” shares of the merging parties that are based on that broader market are under-representations of the potential for their post-merger exercise of market power.

    With a vertical merger, the potential for similar unilateral effects* would have to be captured by examining the detailed sales and substitution patterns of each of the merging firms with all of their significant horizontal competitors. This will require a substantial, data-intensive effort. And, of course, if this effort is not undertaken and an erroneously broader market is designated, the 20% “market” share threshold will understate the potential for competitive harm from a proposed vertical merger.

    * With a vertical merger, such “unilateral effects” could arise post-merger in two ways: (a) The downstream partner could maintain a higher price, since some of the lost profits from some of the lost sales could be recaptured by the upstream partner’s profits on the sales of components to the downstream rivals (which gain some of the lost sales); and (b) the upstream partner could maintain a higher price to the downstream rivals, since some of the latter firms’ customers (and the concomitant profits) would be captured by the downstream partner.

    In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Justice Department, Market Definition, Merger Guidelines, Truth on the Market, Tying , , , , , , , ,
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    Rybnicek: The Draft Vertical Merger Guidelines Would Do More Harm Than Good

    Jan Rybnicek —  7 February 2020

    [TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

    This post is authored by Jan Rybnicek (Counsel at Freshfields Bruckhaus Deringer US LLP in Washington, D.C. and Senior Fellow and Adjunct Professor at the Global Antitrust Institute at the Antonin Scalia Law School at George Mason University).]

    In an area where it may seem that agreement is rare, there is near universal agreement on the benefits of withdrawing the DOJ’s 1984 Non-Horizontal Merger Guidelines. The 1984 Guidelines do not reflect current agency thinking on vertical mergers and are not relied upon by businesses or practitioners to anticipate how the agencies may review a vertical transaction. The more difficult question is whether the agencies should now replace the 1984 Guidelines and, if so, what the modern guidelines should say.

    There are several important reasons that counsel against issuing new vertical merger guidelines (VMGs). Most significantly, we likely are better off without new VMGs because they invariably will (1) send the wrong message to agency staff about the relative importance of vertical merger enforcement compared to other agency priorities, (2) create new sufficient conditions that tend to trigger wasteful investigations and erroneous enforcement actions, and (3) add very little, if anything, to our understanding of when the agencies will or will not pursue an in-depth investigation or enforcement action of a vertical merger.

    Unfortunately, these problems are magnified rather than mitigated by the draft VMGs. But it is unlikely at this point that the agencies will hit the brakes and not issue new VMGs. The agencies therefore should make several key changes that would help prevent the final VMGs from causing more harm than good.

    What is the Purpose of Agency Guidelines? 

    Before we can have a meaningful conversation about whether the draft VMGs are good or bad for the world, or how they can be improved to ensure they contribute positively to antitrust law, it is important to identify, and have a shared understanding about, the purpose of guidelines and their potential benefits.

    In general, I am supportive of guidelines. In fact, I helped urge the FTC to issue its 2015 Policy Statement articulating the agency’s enforcement principles under its Section 5 Unfair Methods of Competition authority. As I have written before, guidelines can be useful if they accomplish two important goals: (1) provide insight and transparency to businesses and practitioners about the agencies’ analytical approach to an issue and (2) offer agency staff direction as to agency priorities while cabining the agencies’ broad discretion by tethering investigational or enforcement decisions to those guidelines. An additional benefit may be that the guidelines also could prove useful to courts interpreting or applying the antitrust laws.

    Transparency is important for the obvious reason that it allows the business community and practitioners to know how the agencies will apply the antitrust laws and thereby allows them to evaluate if a specific merger or business arrangement is likely to receive scrutiny. But guidelines are not only consumed by the public. They also are used by agency staff. As a result, guidelines invariably influence how staff approaches a matter, including whether to open an investigation, how in-depth that investigation is, and whether to recommend an enforcement action. Lastly, for guidelines to be meaningful, they also must accurately reflect agency practice, which requires the agencies’ analysis to be tethered to an analytical framework.

    As discussed below, there are many reasons to doubt that the draft VMGs can deliver on these goals.

    Draft VMGs Will Lead to Bad Enforcement Policy While Providing Little Benefit

     A chief concern with VMGs is that they will inadvertently usher in a new enforcement regime that treats horizontal and vertical mergers as co-equal enforcement priorities despite the mountain of evidence, not to mention simple logic, that mergers among competitors are a significantly greater threat to competition than are vertical mergers. The draft VMGs exacerbate rather than mitigate this risk by creating a false equivalence between vertical and horizontal merger enforcement and by establishing new minimum conditions that are likely to lead the agencies to pursue wasteful investigations of vertical transactions. And the draft VMGs do all this without meaningfully advancing our understanding of the conditions under which the agencies are likely to pursue investigations and enforcement against vertical mergers.

    1. No Recognition of the Differences Between Horizontal and Vertical Mergers

    One striking feature of the draft VMGs is that they fail to contextualize vertical mergers in the broader antitrust landscape. As a result, it is easy to walk away from the draft VMGs with the impression that vertical mergers are as likely to lead to anticompetitive harm as are horizontal mergers. That is a position not supported by the economic evidence or logic. It is of course true that vertical mergers can result in competitive harm; that is not a seriously contested point. But it is important to acknowledge and provide background for why that harm is significantly less likely than in horizontal cases. That difference should inform agency enforcement priorities. Potentially due to this the lack of framing, the draft VMGs tend to speak more about when the agencies may identify competitive harm rather than when they will not.

    The draft VMGs would benefit greatly from a more comprehensive approach to understanding vertical merger transactions. The agencies should add language explaining that, whereas a consensus exists that eliminating a direct competitor always tends to increase the risk of unilateral effects (although often trivially), there is no such consensus that harm will result from the combination of complementary assets. In fact, the current evidence shows such vertical transactions tend to be procompetitive. Absent such language, the VMGs will over time misguidedly focus more agency resources into investigating vertical mergers where there is unlikely to be harm (with inevitably more enforcement errors) and less time on more important priorities, such as pursuing enforcement of anticompetitive horizontal transactions.

    2. The 20% Safe Harbor Provides No Harbor and Will Become a Sufficient Condition

    The draft VMGs attempt to provide businesses with guidance about the types of transactions the agencies will not investigate by articulating a market share safe harbor. But that safe harbor does not (1) appear to be grounded in any evidence, (2) is surprisingly low in comparison to the EU vertical merger guidelines, and (3) is likely to become a sufficient condition to trigger an in-depth investigation or enforcement. 

    The draft VMGs state:

    The Agencies are unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 20%, and the related product is used in less than 20% of the relevant market.

    But in the very next sentence the draft VMGs render the safe harbor virtually meaningless, stating:

    In some circumstance, mergers with shares below the threshold can give rise to competitive concerns.

    This caveat comes despite the fact that the 20% threshold is low compared to other jurisdictions. Indeed, the EU’s guidelines create a 30% safe harbor. Nor is it clear what the basis is for the 20% threshold, either in economics or law. While it is important for the agencies to remain flexible, too much flexibility will render the draft VMGs meaningless. The draft VMGs should be less equivocal about the types of mergers that will not receive significant scrutiny and are unlikely to be the subject of enforcement action.

    What may be most troubling about the market share safe harbor is the likelihood that it will establish general enforcement norms that did not previously exist. It is likely that agency staff will soon interpret (despite language stating otherwise) the 20% market share as the minimum necessary condition to open an in-depth investigation and to pursue an enforcement action. We have seen other guidelines’ tools have similar effects on agency analysis before (see, GUPPIs). This risk is only exacerbated where the safe harbor is not a true safe harbor that provides businesses with clarity on enforcement priorities.

    3. Requirements for Proving EDM and Efficiencies Fails to Recognize Vertical Merger Context

    The draft VMGs minimize the significant role of EDM and efficiencies in vertical mergers. The agencies frequently take a skeptical approach to efficiencies in the context of horizontal mergers and it is well-known that the hurdle to substantiate efficiencies is difficult, if not impossible, to meet. The draft VMGs oddly continue this skeptical approach by specifically referencing the standards discussed in the horizontal merger guidelines for efficiencies when discussing EDM and vertical merger efficiencies. The draft VMGs do not recognize that the combination of complementary products is inherently more likely to generate efficiencies than in horizontal mergers between competitors. The draft VMGs also oddly discuss EDM and efficiencies in separate sections and spend a trivial amount of time on what is the core motivating feature of vertical mergers. Even the discussion of EDM is as much about where there may be exceptions to EDM as it is about making clear the uncontroversial view that EDM is frequent in vertical transactions. Without acknowledging the inherent nature of EDM and efficiencies more generally, the final VMGs will send the wrong message that vertical merger enforcement should be on par with horizontal merger enforcement.

    4. No New Insights into How Agencies Will Assess Vertical Mergers

    Some might argue that the costs associated with the draft VMGs nevertheless are tolerable because the guidelines offer significant benefits that far outweigh their costs. But that is not the case here. The draft VMGs provide no new information about how the agencies will review vertical merger transactions and under what circumstances they are likely to seek enforcement actions. And that is because it is a difficult if not impossible task to identify any such general guiding principles. Indeed, unlike in the context of horizontal transactions where an increase in market power informs our thinking about the likely competitive effects, greater market power in the context of a vertical transaction that combines complements creates downward pricing pressure that often will dominate any potential competitive harm.

    The draft VMGs do what they can, though, which is to describe in general terms several theories of harm. But the benefits from that exercise are modest and do not outweigh the significant risks discussed above. The theories described are neither novel or unknown to the public today. Nor do the draft VMGs explain any significant new thinking on vertical mergers, likely because there has been none that can provide insight into general enforcement principles. The draft VMGs also do not clarify changes to statutory text (because it has not changed) or otherwise clarify judicial rulings or past enforcement actions. As a result, the draft VMGs do not offer sufficient benefits that would outweigh their substantial cost.

    Conclusion

    Despite these concerns, it is worth acknowledging the work the FTC and DOJ have put into preparing the draft VMGs. It is no small task to articulate a unified position between the two agencies on an issue such as vertical merger enforcement where so many have such strong views. To the agencies’ credit, the VMGs are restrained in not including novel or more adventurous theories of harm. I anticipate the DOJ and FTC will engage with commentators and take the feedback seriously as they work to improve the final VMGs.

    In Antitrust & Competition, Constitutional Law, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, European Union, Exemptions, Federal Trade Commission, International, Justice Department, Market Definition, Merger Guidelines, Section 5, Supreme Court, Truth on the Market, Tying , , , , , , , , ,
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    Sher: Implications of the Draft Vertical Merger Guidelines for Vertical Mergers Involving Technology Start-Ups

    Scott Sher —  7 February 2020

    [TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

    This post is authored by Scott Sher (Partner, Wilson Sonsini Goodrich & Rosati) and Matthew McDonald (Associate, Wilson Sonsini Goodrich & Rosati).]

    On January 10, 2020, the United States Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”) (collectively, “the Agencies”) released their joint draft guidelines outlining their “principal analytical techniques, practices and enforcement policy” with respect to vertical mergers (“Draft Guidelines”). While the Draft Guidelines describe and formalize the Agencies’ existing approaches when investigating vertical mergers, they leave several policy questions unanswered. In particular, the Draft Guidelines do not address how the Agencies might approach the issue of acquisition of potential or nascent competitors through vertical mergers. As many technology mergers are motivated by the desire to enter new industries or add new tools or features to an existing platform (i.e., the Buy-Versus-Build dilemma), the omission leaves a significant hole in the Agencies’ enforcement policy agenda, and leaves the tech industry, in particular, without adequate guidance as to how the Agencies may address these issues.

    This is notable, given that the Horizontal Merger Guidelines explicitly address potential competition theories of harm (e.g., at § 1 (referencing mergers and acquisitions “involving actual or potential competitors”); § 2 (“The Agencies consider whether the merging firms have been, or likely will become absent the merger, substantial head-to-head competitors.”). Indeed, the Agencies have recently challenged several proposed horizontal mergers based on nascent competition theories of harm. 

    Further, there has been much debate regarding whether increased antitrust scrutiny of vertical acquisitions of nascent competitors, particularly in technology markets, is warranted (See, e.g., Open Markets Institute, The Urgent Need for Strong Vertical Merger Guidelines (“Enforcers should be vigilant toward dominant platforms’ acquisitions of seemingly small or marginal firms and be ready to block acquisitions that may be part of a monopoly protection strategy. Dominant firms should not be permitted to expand through vertical acquisitions and cut off budding threats before they have a chance to bloom.”); Caroline Holland, Taking on Big Tech Through Merger Enforcement (“Vertical mergers that create market power capable of stifling competition could be particularly pernicious when it comes to digital platforms.”)). 

    Thus, further policy guidance from the Agencies on this issue is needed. As the Agencies formulate guidance, they should take note that vertical mergers involving technology start-ups generally promote efficiency and innovation, and that any potential competitive harm almost always can be addressed with easy-to-implement behavioral remedies.

    The agencies’ draft vertical merger guidelines

    The Draft Guidelines outline the following principles that the Agencies will apply when analyzing vertical mergers:

    • Market definition. The Agencies will identify a relevant market and one or more “related products.” (§ 2) This is a product that is supplied by the merged firm, is vertically related to the product in the relevant market, and to which access by the merged firm’s rivals affects competition in the relevant market. (§ 2)
    • Safe harbor. Unlike horizontal merger cases, the Agencies cannot rely on changes in concentration in the relevant market as a screen for competitive effects. Instead, the Agencies consider measures of the competitive significance of the related product. (§ 3) The Draft Guidelines propose a safe harbor, stating that the Agencies are unlikely to challenge a vertical merger “where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.” (§ 3) However, shares exceeding the thresholds, taken alone, do not support an inference that the vertical merger is anticompetitive. (§ 3)
    • Theories of unilateral harm. Vertical mergers can result in unilateral competitive effects, including raising rivals’ costs (charging rivals in the relevant market a higher price for the related product) or foreclosure (refusing to supply rivals with the related product altogether). (§ 5.a) Another potential unilateral effect is access to competitively sensitive information: The combined firm may, through the acquisition, gain access to sensitive business information about its upstream or downstream rivals that was unavailable to it before the merger (for example, a downstream rival of the merged firm may have been a premerger customer of the upstream merging party). (§ 5.b)
    • Theories of coordinated harm. Vertical mergers can also increase the likelihood of post-merger coordinated interaction. For example, a vertical merger might eliminate or hobble a maverick firm that would otherwise play an important role in limiting anticompetitive coordination. (§ 7)
    • Procompetitive effects. Vertical mergers can have procompetitive effects, such as the elimination of double marginalization (“EDM”). A merger of vertically related firms can create an incentive for the combined entity to lower prices on the downstream product, because it will capture the additional margins from increased sales on the upstream product. (§ 6) EDM thus may benefit both the merged firm and buyers of the downstream product. (§ 6)
    • Efficiencies. Vertical mergers have the potential to create cognizable efficiencies; the Agencies will evaluate such efficiencies using the standards set out in the Horizontal Merger Guidelines. (§ 8)

    Implications for vertical mergers involving nascent start-ups

    At present, the Draft Guidelines do not address theories of nascent or potential competition. To the extent the Agencies provide further guidance regarding the treatment of vertical mergers involving nascent start-ups, they should take note of the following facts:

    First, empirical evidence from strategy literature indicates that technology-related vertical mergers are likely to be efficiency-enhancing. In a survey of the strategy literature on vertical integration, Professor D. Daniel Sokol observed that vertical acquisitions involving technology start-ups are “largely complementary, combining the strengths of the acquiring firm in process innovation with the product innovation of the target firms.” (p. 1372) The literature shows that larger firms tend to be relatively poor at developing new and improved products outside of their core expertise, but are relatively strong at process innovation (developing new and improved methods of production, distribution, support, and the like). (Sokol, p. 1373) Larger firms need acquisitions to help with innovation; acquisition is more efficient than attempting to innovate through internal efforts. (Sokol, p. 1373)

    Second, vertical merger policy towards nascent competitor acquisitions has important implications for the rate of start-up formation, and the innovation that results. Entrepreneurship in technology markets is motivated by the opportunity for commercialization and exit. (Sokol, p. 1362 (“[T]he purpose of such investment [in start-ups] is to reap the rewards of scaling a venture to exit.”))

    In recent years, as IPO activity has declined, vertical mergers have become the default method of entrepreneurial exit. (Sokol, p. 1376) Increased vertical merger enforcement against start-up acquisitions thus closes off the primary exit strategy for entrepreneurs. As Prof. Sokol concluded in his study of vertical mergers:

    When antitrust agencies, judges, and legislators limit the possibility of vertical mergers as an exit strategy for start-up firms, it creates risk for innovation and entrepreneurship…. it threatens entrepreneurial exits, particularly for tech companies whose very business model is premised upon vertical mergers for purposes of a liquidity event. (p. 1377)

    Third, to the extent that the vertical acquisition of a start-up raises competitive concerns, a behavioral remedy is usually preferable to a structural one. As explained above, vertical acquisitions typically result in substantial efficiencies, and these efficiencies are likely to overwhelm any potential competitive harm. Further, a structural remedy is likely infeasible in the case of a start-up acquisition. Thus, behavioral relief is the only way of preserving the deal’s efficiencies while remedying the potential competitive harm. (Which the Agencies have recognized, see DOJ Antitrust Division, Policy Guide to Merger Remedies, p. 20 (“Stand-alone conduct relief is only appropriate when a full-stop prohibition of the merger would sacrifice significant efficiencies and a structural remedy would similarly eliminate such efficiencies or is simply infeasible.”)) Appropriate behavioral remedies for vertical acquisitions of start-ups would include firewalls (restricting the flow of competitively sensitive information between the upstream and downstream units of the combined firm) or a fair dealing or non-discrimination remedy (requiring the merging firm to supply an input or grant customer access to competitors in a non-discriminatory way) with clear benchmarks to ensure compliance. (See Policy Guide to Merger Remedies, pp. 22-24)

    To be sure, some vertical mergers may cause harm to competition, and there should be enforcement when the facts justify it. But vertical mergers involving technology start-ups generally enhance efficiency and promote innovation. Antitrust’s goals of promoting competition and innovation are thus best served by taking a measured approach towards vertical mergers involving technology start-ups. (Sokol, pp. 1362–63) (“Thus, a general inference that makes vertical acquisitions, particularly in tech, more difficult to approve leads to direct contravention of antitrust’s role in promoting competition and innovation.”)

    In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Federal Trade Commission, Justice Department, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Tying , , , , , , , , , , , ,
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    Pozen: The Missed Opportunity for International Harmonization in the Draft Vertical Merger Guidelines

    Sharis Pozen —  7 February 2020

    [TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

    This post is authored by Sharis Pozen (Partner, Clifford Chance; former Vice President of Global Competition Law and Policy, GE; former Acting Assistant Attorney General, DOJ Antitrust Division); with Timothy Cornell (Partner, Clifford Chance); Brian Concklin (Counsel, Clifford Chance); and Michael Van Arsdall (Counsel, Clifford Chance).]

    The draft Vertical Merger Guidelines (“Guidelines”) miss a real opportunity to provide businesses with consistent guidance across jurisdictions and to harmonize the international approach to vertical merger review. 

    As drafted, the Guidelines indicate the agencies will evaluate market shares and concentration — measured using the same methodology described in the long-standing Horizontal Merger Guidelines — but not use these metrics as a “rigid screen.” On that basis the Guidelines establish a “soft” 20 percent threshold, where the U.S. Agencies are “unlikely to challenge a vertical merger” if the merging parties have less than a 20 percent share of the relevant market and the related product is used in less than 20 percent of the relevant market.

    We suggest, instead, that the Guidelines be aligned with those of other jurisdictions, namely the EU non-horizontal merger guidelines [for an extended discussion of which, see Bill Kolaasky’s symposium post here —ed.]. The European Commission’s guidelines state the European Commission is “unlikely to find concern” with a vertical merger affecting less than 30 percent of the relevant markets and the post-merger HHIs fall below 2000. Among others, Japan and Chile employ a similarly higher bar than the Guidelines. A discrepancy between the U.S. and other international guidelines causes unnecessary uncertainty within the business and legal communities and could lead to inconsistent enforcement outcomes.In any event, beyond the dangers created by a lack of international harmonization, setting the threshold at 20 percent seems arbitrarily low given the pro-competitive nature of most vertical mergers. Setting the threshold so low fails to recognize the inherently procompetitive nature of the majority of vertical combinations, and could result in false positives, and undue cost and delay.

    In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, European Union, Exemptions, Federal Trade Commission, International, Justice Department, Market Definition, Merger Guidelines, Truth on the Market, Tying , , , , , , , ,
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